Document of The World Bank

FOR OFFICIAL USE ONLY Report No. 81945-BR

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED LOAN

IN THE AMOUNT OF US$500 MILLION TO

THE STATE OF RIO DE JANEIRO

WITH THE GUARANTEE OF THE FEDERATIVE REPUBLIC OF BRAZIL

FOR THE

ENHANCING PUBLIC MANAGEMENT FOR SERVICE DELIVERY IN RIO DE JANEIRO

DEVELOPMENT POLICY OPERATION

October 23, 2013

Sustainable Development Department Poverty Reduction and Economic Management Department Brazil Country Management Unit Latin America and the Caribbean Region

This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank’s Policy on Access to Information.

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BRAZIL - GOVERNMENT FISCAL YEAR January 1 – December 31

CURRENCY EQUIVALENTS (Exchange Rate Effective October 21, 2013)

Currency Unit = Brazil Real R$ 1.00 = US$ 0.46

US$ 1.00 = R$ 2.17

ABBREVIATION AND ACRONYMS

AGE Internal Audit Department Auditoria Geral do Estado AMTU Metropolitan Agency for Urban Transport Agência Metropolitana de Transportes Urbanos BCB Central Bank of Brazil Banco Central do Brasil BNDES National Bank of Economic and Social Development Banco Nacional de Desenvolvimento Econômico e Social BRT Bus Rapid Transit Transporte Rápido por Ônibus BUI Inter-Municipal Integrated Fare Scheme Bilhete Único Intermunicipal BUC Municipal Integrated Fare Scheme Bilhete Único Carioca Casa Civil Office of the Chief of Staff Secretaria de Estado da Casa Civil CPS Country Partnership Strategy Estratégia de Parceria com o País DETRO Road Transport Department Departamento de Transportes Rodoviários DPL Development Policy Loan Empréstimo para Políticas de Desenvolvimento FDI Foreign Direct Investment Investimento Estrangeiro Direto FGC Deposit Insurance Fund Fundo Garantidor de Créditos FY Fiscal year Ano Fiscal GDP Gross Domestic Product Produto Interno Bruto GoB Government of Brazil Governo do Brasil GORJ Government of the State of Rio de Janeiro Governo do Estado do Rio de Janeiro IDB Inter-American Development Bank Banco Interamericano de Desenvolvimento

IBRD International Bank for Reconstruction and Development

Banco Internacional para Reconstrução e Desenvolvimento

IMF International Monetary Fund Fundo Monetário Internacional LDO Budget Guidelines Law Lei de Diretrizes Orçamentárias

LMDP Maria da Penha Law (Domestic Violence Prevention Legislation)

Lei Maria da Penha

LOA Annual Budget Law Lei de Orçamento Anual LRF Fiscal Responsibility Law Lei de Responsabilidade Fiscal MRJ Municipality of Rio de Janeiro Cidade de Rio de Janeiro NCR Net Current Revenue Receita Corrente Líquida NMT Non-motorized Transport Transporte não Motorizado PAF Program of Fiscal Adjustment Programa de Ajuste Fiscal

PDTU Master Plan on Urban Transport in the RJMR Plano Diretor de Transporte Urbano da Região Metropolitana do Rio de Janeiro

PEFA Public Expenditure and Financial Accountability Método de despesa pública e responsabilidade financeira PFM Public Financial Management Gestão de Finanças Públicas PPA Multi-year Plan Plano Plurianual PPP Public-Private Partnerships Parcerias Público-Privadas REGIN Integrated Recording System for taxes Sistema de Registro Integrado RJMR Rio de Janeiro Metropolitan Region Região Metropolitana do Rio de Janeiro SRJ State of Rio de Janeiro Estado de Rio de Janeiro SEASDH State Secretariat of Social Welfare and Human Rights Secretaria de Estado Assistência Social e Direitos Humanos SEFAZ State Secretariat of Finance Secretaria de Estado da Fazenda

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SETRANS State Secretariat of Transport Secretaria de Estado de Transportes SIL Specific Investment Loan Empréstimo para Investimento Específico STN National Treasury Secretariat Secretaria do Tesouro Nacional SUPERVIA Suburban Rail Operator in the RJMR Operador do sistema de trens urbanos SWAP Sector Wide Approach Abordagem Setorial Ampla TAL Technical Assistance Loan Empréstimo para Assistência Técnica TCE Court of Accounts of the State Tribunal de Contas do Estado

Vice President: Hasan A. Tuluy Country Director: Deborah L. Wetzel

Sector Director: Sector Manager:

Ede Jorge Ijjasz-Vasquez Aurelio Menendez

Task Team Leader: Shomik Raj Mehndiratta/Georges Darido

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BRAZIL

ENHANCING PUBLIC MANAGEMENT FOR SERVICE DELIVERY IN RIO DE JANEIRO

DEVELOPMENT POLICY OPERATION

TABLE OF CONTENTS  

1.  INTRODUCTION AND COUNTRY CONTEXT ............................................................ 1 2.  MACROECONOMIC POLICY FRAMEWORK ............................................................ 4 2.1  RECENT ECONOMIC DEVELOPMENTS IN BRAZIL ............................................................................... 4 

2.1  MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ........................................................... 6 

2.2  RECENT ECONOMIC DEVELOPMENTS IN RIO DE JANEIRO .............................................................. 9 

2.3  MACROECONOMIC OUTLOOK FOR RIO DE JANEIRO ....................................................................... 11 

2.4  IMF RELATIONS ............................................................................................................................................. 12 

3.  THE GOVERNMENT’S PROGRAM ............................................................................. 12 4.  PROPOSED OPERATION .............................................................................................. 15 4.1  LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION ......................................... 15 

4.2  PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS .................................................. 16 

4.3  LINK TO COUNTRY PARTNERHSIP STRATEGY (CPS) AND OTHER BANK OPERATIONS........ 25 

4.4  CONSULTATIONS AND COLLABORATION WITH OTHER DEVELOPMENT PARTNERS ........... 26 

5.  OTHER DESIGN AND APPRAISAL ISSUES .............................................................. 27 5.1  POVERTY AND SOCIAL IMPACT ............................................................................................................... 27 

5.2  ENVIRONMENTAL ASPECTS ...................................................................................................................... 28 

5.3  PFM, DISBURSEMENT AND AUDITING ASPECTS ................................................................................. 29 

5.4  MONITORING AND EVALUATION ............................................................................................................. 31 

6.  SUMMARY OF RISKS AND MITIGATION ................................................................ 32 ANNEX 1. LETTER OF DEVELOPMENT POLICY ........................................................................................... 34 

ANNEX 2. OPERATION POLICY MATRIX – RESULTS INDICATORS ....................................................... 52 

ANNEX 3. FUND RELATIONS NOTE ................................................................................................................. 56 

ANNEX 4. FISCAL SUSTAINABILITY ANALYSIS .......................................................................................... 59 

ANNEX 5. BRAZIL AT A GLANCE ...................................................................................................................... 70 

ANNEX 6. RIO AT A GLANCE .............................................................................................................................. 72 

The Enhancing Public Management for Service Delivery DPL was prepared by an IBRD team consisting of Shomik Raj Mehndiratta, Georges Darido, Daniel Pulido, Fabio Hirschhorn, Hanayo Taguchi, Boris Utria, Roland Clarke, Rafael Chelles Barroso, Fabio Sola Bittar, Joseph Kizito, Alberto Coelho Gomes Costa, Márcio Batitucci, Miriam Muller, Astrid Helgeland, Christine M. Richaud, Catarina Isabel Portelo, Etel Patricia Bereslawski, and Patricia Hoyes.

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LOAN AND PROGRAM SUMMARY

BRAZIL

ENHANCING PUBLIC MANAGEMENT FOR SERVICE DELIVERY IN RIO DE JANEIRO DEVELOPMENT POLICY OPERATION

Borrower: The State of Rio de Janeiro (SRJ) with a guarantee from the Federative Republic of Brazil

Implementing Agencies:

Casa Civil (Office of the Chief of Staff), State Secretariat of Transportation (SETRANS), State Secretariat of Finance (SEFAZ) and State Secretariat of Social Welfare and Human Rights (SEASDH)

Financing Data:

Amount: US$500 million with a sovereign guarantee from the Federative Republic of Brazil Terms: IBRD Flexible Loan (IFL) with Variable spread over Libor; 10-years grace period and 26-year total maturity Front end fee: 0.25% paid by the Borrower from its own resources

Operation Type: Single tranche Development Policy Loan (DPL).

Operation Pillars and Program Development Objective (PDO):

Assist the Government of Rio de Janeiro (GORJ) in its efforts to enhance public management for the delivery of key public services for vulnerable populations by instituting new policies and regulations to improve: the medium term planning and monitoring of public expenditures (Policy Area 1); the accessibility, quality and affordability of urban mobility services for the poor (Policy Area 2); and the availability of targeted social services aimed at reducing domestic and gender based violence (Policy Area 3). This objective directly contributes to the poverty reduction and shared prosperity agendas, insofar as financially-sustainable and targeted urban mobility and social support services benefiting the poor and other populations at risk, such as women, enable more equitable access to economic and social opportunities, allowing the benefits of growth to be shared more widely.

Results Indicators:

Policy Area 1: Instituting policies to improve medium-term planning and monitoring of public expenditures

Policy Objective 1.1: Adopt sound financial and debt management policies and practices Maintenance of the number of events (occurrences and non-conformities) in which the

operational risk policy procedures were not complied with within already achieved satisfactory levels. Baseline= [occurrences = 52; non-conformities = 12] (2012); Target = [occurrence = 48; non-conformities = 11] (2014)

Reduction in the number of times in a year that the actual monthly cash balance has remained below the minimum threshold (set at 1.5 times the payroll amount). Baseline= 3 out of 12 (2012); Target = 2 out of 12 (2014)

Reduction in the percentage of payments made after 30 days. Baseline=3.6% (2012); Target = 3.0% (2014)

Policy Objective 1.2: Strengthen the definition of the budget resource envelope under a Medium-Term Expenditure Framework (MTEF) Reduction in the gap between actual and estimated current revenues, measured as a share of

the estimated revenues. Baseline= 6.6% (average 2010-2012); Target = 5% (2014) Publication in the internet of revenue estimates documents for the 2014 budget. Baseline= No

(2012); Target = Yes (2014) Annual Budget directive issued for the 2015 budget cycle. Baseline= No (2012); Target = Yes

(2014) Policy Objective 1.3: Implement a framework to deal with fiscal commitments originated from Public-Private Partnerships (PPPs) A comprehensive report including current and prospective long-term commitments and

liabilities associated to PPPs is published as scheduled. Baseline= No (2012); Target = Yes (2014)

All PPP-related bidding documents, contracts and supporting analysis are published on a dedicated website in a timely manner. Baseline= No (2012); Target = Yes (2014).

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Policy Area 2: Instituting policies and regulations to improve the accessibility, quality and affordability of urban mobility services for the poor

Policy Objective 2.1: Foster Modal Integration in urban transport systems Permanent Committee for the implementation of the PDTU, involving relevant government

and civil society actors, meets at least four (4) times in its first year of existence and presents strategy for the implementation of at least one (1) priority project under the PDTU. Baseline= 0 (December 2013); Target= 4 meetings and 1 PDTU project discussed (December 2014).

No transport project outside of the PDTU (i.e. not endorsed by PDTU) will be undertaken by the GORJ.

At least one (1) multimodal integration project, connecting state and municipal transit systems, is completed. Baseline= 0 (December 2013); Target =1 (December 2014).

State prepares guidelines for the development of bicycle-public transit integration projects to be implemented by metropolitan municipalities and at least one (1) of these projects is implemented with the State’s technical assistance. Baseline = 0 projects (December 2013); Target = 1 project (December 2014).

Policy Objective 2.2:Enhance Performance and Transparency of Inter-Municipal Bus Services The concession bidding documents will identify the bus lines to be sectioned or eliminated in

order to prioritize integration with mass transit modes (name, current code, and in the cases of sectioning, new extension, new fleet and estimated demand). Baseline= 0 lines (December 2013); Target = 19 lines are identified and reorganized or eliminated. (December 2014)

Inter-municipal bus lines in the RJMR (previously provided under permission regime) are in operation under new concession agreements incorporating performance monitoring. Baseline= 0 lines (December 2013); Target = 50% of the bus lines under the new route plan are awarded to competitively selected concessionaires (December 2014)

Service reliability, fleet modernization and vehicle occupation requirements are properly monitored and enforced on inter-municipal bus concessions in operation. Baseline = N.A. (December 2013); Target = 80% of bus concessions either comply with requirements or are penalized (December 2014).

Policy Objective 2.3:Ensure the long-term sustainability and effectiveness of the State’s urban transport subsidy / affordability programs New operations contract awarded for the Teleférico System incorporates performance

monitoring, availability-based remuneration, and incentives for maximizing ancillary revenue; and results in a reduction in the operational subsidies paid by the State. Baseline= System operated under temporary arrangement with a subsidy of R$14.00/passenger/trip (2013); Target=new operational contract results in a 5% reduction in the subsidy per passenger/trip and is monitored and remunerated using performance indicators (December 2014)

Policy Area 3: Instituting policies and regulations to improve the availability of targeted social services aimed at reducing domestic and gender based violence

Policy objective 3.1: Implement the Maria da Penha Law by leveraging transport infrastructure for improved delivery and targeting of services Number of women benefiting from increased access to information and to social and legal

services as per the provisions of the “Lei Maria da Penha” within the Supervia and Teleférico systems. Baseline = 0 (December 2013); Target =50,000 (December 2014)

Increase in the number of women benefiting from the integration of the Supervia and Teleférico systems to the “Casa da Mulher Brasileira”: Baseline = 0 (December 2013); Target = 1,000 (December 2014)

Overall Risk Rating:

Substantial

Operation ID: P147695

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IBRD PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY OPERATION TO THE STATE OF RIO DE JANEIRO

(BRAZIL) FOR ENHANCING PUBLIC MANAGEMENT FOR SERVICE DELIVERY IN RIO DE

JANEIRO

1. INTRODUCTION AND COUNTRY CONTEXT

1. This Program Document presents a proposed stand-alone Development Policy Loan (DPL) in the amount of US$500 million for the State of Rio de Janeiro (SRJ), Brazil. The objective of this DPL is to assist the State Government in its efforts to enhance public management for the delivery of key public services for vulnerable populations by instituting new policies and regulations to improve: the medium-term planning and monitoring of public expenditures (Policy Area 1); improve the accessibility, quality and affordability of urban mobility services for the poor (Policy Area 2); and the availability of targeted social services aimed at reducing domestic and gender based violence (Policy Area 3). This objective directly contributes to the poverty reduction and shared prosperity agendas, insofar as financially-sustainable and targeted urban mobility and social support services benefiting the poor and other populations at risk, such as women, enable more equitable access to economic and social opportunities, allowing the benefits of growth to be shared more widely. Although requested as a stand-alone DPL, the operation forms part of a long term quasi-programmatic engagement with the State, including previous DPLs, and builds on ongoing policy dialog, analytical work and investment lending operations.

2. Despite considerable improvements in the last decade, public service delivery in the State in General, and in the Rio de Janeiro Metropolitan Region (RJMR) especially, has not kept up with the growing expectations of the population.1 In particular, citizen dissatisfaction with public transport service quality and tariffs was one of the catalysts for the protests that paralyzed many Brazilian metropolitan areas, including the RJMR, in June of 2013. More generally, the protests reflected a  broader perception of inadequate public services, of concerns with overall government investments and management, and of frustration with prosperity not shared. In many important ways these protests have increased the pressure on governments across Brazil to implement significant reforms to improve public service delivery and enhance the quality of public sector management.

3. This DPL supports important reforms in public sector management and service delivery that are fundamental for meeting citizen expectations, of both the poor and of the middle-class, and complements previous operations. The proposed operation will focus on three key areas. First, it supports better medium-term planning and monitoring of public expenditures, which in turn ensures that public service delivery can be improved and sustained over time in a fiscally responsible manner. Second, it promotes reforms to improve urban mobility services in the RJMR, whose quality is often ranked as of the worst among Brazil’s major metropolitan areas. Finally, it supports new policies to better deploy social services addressing domestic and gender-based violence. By focusing on these areas, the operation builds upon and complements previous DPLs that focused on strengthening public management and 1 The Rio de Janeiro Metropolitan Region (RJMR) comprises 19 municipalities, of which the Municipality of Rio de Janeiro (MRJ) is the most important. The MRJ contributes 50 percent of the State’s Gross Domestic Product (GDP), equivalent to 69 percent of the RJMR’s GDP, and 74 percent of the State’s 16 million inhabitants live in the RJMR.

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improving the delivery of other key public services including: health and education services (Rio State DPL III, approved in August 2012 and the Fiscal Sustainability, Human Development and Competitiveness DPL approved in February 2010); housing and urban services (Rio de Janeiro Metropolitan Urban and Housing Development DPL, approved in March 2011); and business support services (Fiscal Sustainability, Human Development and Competitiveness DPL).

4. This DPL also capitalizes on the strategic relationship that the Bank has built over two decades of engagement with the SRJ, as the supported reforms provide an opportunity to achieve a substantial development impact and to create a powerful demonstration effect. First, this program highlights how a subnational government can leverage its partnership with the Bank to advance and consolidate reforms that tackle challenging development issues. Moreover, the program also serves as an important platform for innovation – pioneering a number of potentially catalytic reforms in urban mobility and gender that have important demonstration potential across Brazil and the region. These include: first and more broadly, reinforcing reforms in Public Finance Management (PFM) and medium-term budget planning capacity to ensure that services are reliable and sustainable; fostering regional and modal integration of mobility systems, including the use of non-motorized modes; introducing modern and transparent performance-based bus concessions that are monitored through new technologies that enable open access to operational data and increase transparency for users; introducing a sustainability policy to continuously improve the cost-effectiveness and financial viability of urban transport subsidies; and building on Brazil’s domestic and gender-based violence prevention legislation (“Lei Maria da Penha”-LMDP) and on a year-long policy dialogue by operationalizing innovative social services to reduce domestic and gender-based violence, leveraging transport infrastructure facilities for broader delivery and improved targeting.

5. Despite its relative wealth, the SRJ faces important challenges to reduce poverty and boost shared prosperity. Extreme poverty is higher than those of states with similar average per capita household income.2 While the SRJ has the third largest average per capita household income among Brazilian states, it is ranked 11th in the list of states with incidence of extreme poverty. Also, although income inequality (measured by the Gini coefficient) has decreased, it has done so at a slower pace than in other Brazilian states and is currently at the still high Brazilian average and above all southeastern states.3

6. Since 2007 the State has implemented and perfected several sound PFM and budgeting measures which have improved public service reliability and which need to be institutionalized and consolidated. This will ensure that key public services can be adequately delivered helping to tackle poverty and shared prosperity issues in Rio de Janeiro. Before 2007 the State had no PFM practices established and the budget was controlled on a cash rationing basis. Payments were made based on cash available on the previous day and in a non-transparent way. Furthermore, the imbalances between incoming revenues and budget execution, as well as between cash availability and payments left the State Treasury with negative cash balances overnight on several occasions. These issues have been proactively addressed by this administration. The average cash balance from 2007 to 2012 was R$ 1.3 billion, compared to only R$ 350 million from 2003 to 2006. The average cash balance has

2 The SRJ has an extreme poverty headcount of 3.9 percent, compared to 2.6 percent for São Paulo, 2.2 percent for Santa Catarina, 3.8 percent for Rio Grande do Sul and 2.4 percent for Paraná. 3 The SRJ’s Gini coefficient decreased from 0.568 to 0.532 from 2001 to 2011. However, while in the mid-1990s the State’s level of inequality was lower than the national average, by the end of the 2000s, it was practically equal to the still high Brazilian average.

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fluctuated between 1.5 and 2 times the value of the monthly payroll. The average time for paying suppliers decreased from more than 40 days to an average period of 10 to 15 days. The sustainability of these results now requires the institutionalization of these reforms.

7. Improving urban mobility services in the RJMR can have a large impact on addressing poverty and shared prosperity challenges in the State. The SRJ is the third most populous State in Brazil and the most urbanized, with 74 percent of its 16 million inhabitants living across the 19 municipalities that comprise the RJMR. Although poverty has gone down significantly in the RJMR, close to 30 per cent of the population is either poor or vulnerable to poverty.4 Most low-income families reside in the RJMR’s periphery, while jobs are mainly concentrated in the Municipality of Rio de Janeiro (MRJ), which houses 55 percent of the region’s jobs. This places enormous urban mobility demands in a metropolitan area with a limited mobility system.5 Barriers to urban mobility faced by the low income population, particularly those living at most peripheral areas of the RJMR, contribute to social inequality and exclusion. Despite important gains made in recent years (partially with the support of Bank financing of the suburban rail system), the quality of urban mobility in the RJMR continues to be one of the worst in Brazil, particularly for the poor. It was estimated that, in 2010, a dweller from peripheral municipalities spent an average of 22.4 percent of his/her workday (about 86 minutes per day) commuting.6 In general, the RMRJ has the lowest proportion of workers who take less than half an hour to get to work (around 40 percent in 2009). Relative to other global cities the region has long suffered from an inadequate mass transit infrastructure to support its population.

8. Improving access to targeted services for women is also a key priority. Despite policy advances, violence against women remains an extremely serious problem in the SRJ, particularly in the RJMR. Brazil has been recognized internationally for the “Lei Maria da Penha” (LMDP), one of the most innovative laws on domestic violence worldwide, and whose implementation is the responsibility of State Governments.7 Nonetheless, States have not been able to implement this legislation due in part to lack of resources and physical facilities. A particular barrier observed with regards to the operationalization of the social services contemplated by this law has been the placement of these services in locations that are difficult access for potential beneficiaries.8 This has constrained the State’s ability to service women as a vulnerable group. According to a recent study, the rate of women murdered by men (murders per 100,000 women) in the 2009-2011 period was 6.03 in the SRJ, higher than the average rate of 5.82 reported for the country as a whole and significantly above the rate of 3.74 reported for Sao

4 21.1percent of the RJMR’s residents are vulnerable to poverty; 6.8 percent are poor and 1.9 percent extremely poor. The incidence of poverty peaks in peripheral municipalities such as Tanguá (4.9 percent extreme poverty and 14.4 percent poverty) and Japeri (39.9 percent families vulnerable to poverty). 5 The number of daily trips in the RJMR has grown from 19.9 million in 2003 to 22.6 million in 2012 6 Rafael Pereira and Tim Schwanen, “Tempo de deslocamento casa-trabalho no Brasil (1992-2009): diferenças entre regiões metropolitanas, níveis de renda e sexo. Texto para Discussão No. 1813”. Instituto de Pesquisa Econômica Aplicada (IPEA): Brasília/Rio de Janeiro, 2013. 7 The Maria da Penha law provides for unprecedented measures to protect women in situations of violence or under risk of death. The law changes the Penal Code, allowing an aggressor to be arrested not only in the act of committing an offence, but also preventively, if the aggressor's freedom is determined to be a threat to a victim's life. The law also establishes social measures to assist women. For example, women at risk may be included in government welfare programs, and the law provides for the inclusion of basic information on violence against women in school materials. 8 Perova, Reynolds and Muller (2012)

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Paulo.9 Furthermore, as of 2012, women were the most affected by crimes, such as rape (83 percent incidence), threats (67 percent incidence) and aggravated assault (65 percent incidence). For all these crimes, the percentage of women victims increased between 2005 and 2012. Partners and ex-partners accounted for the highest percentage (36.1 percent) of those accused of attempted homicides committed against women in 2012, and 16.9 percent of female homicides occurred in the context of domestic violence and/or family.

2. MACROECONOMIC POLICY FRAMEWORK

2.1 RECENT ECONOMIC DEVELOPMENTS IN BRAZIL

9. Over the last two decades, Brazil has made significant advances in terms of economic management, poverty reduction, and social indicators. Growth in employment and labor incomes, as well as the implementation of targeted social assistance programs, such as Bolsa Família, have contributed to a reduction in the share of Brazilians living below the extreme poverty line of R$70 a month from 10.5 percent at the start of the 2000s to 4.7 percent in 2011, as well as a reduction in inequality as reflected in a fall in the Gini coefficient from 0.59 to 0.53 over the same period.

10. Brazil’s development is now at a crossroads. The country is gradually recovering from a slowdown that started in mid-2011. Future growth appears to be limited by structural bottlenecks in infrastructure, human capital, and poor financial intermediation compounded by a burdensome tax system and business environment. At the same time, a growing middle class (the result of growth and improved income distribution) is drawing attention to the failings of governance, and the inability to deliver public services such as education, health and transport efficiently and cost-effectively. Mass demonstrations in major cities in Brazil during June 2013 left little doubt as to the importance of good governance and effective service delivery in Brazil.

11. The recent economic slowdown was driven by both domestic and external factors. Tighter monetary and fiscal policies weakened domestic demand. At the same time, external demand was dampened by protracted weakness and uncertainty in advanced economies and slowing growth in major emerging economies such as China. While the slowdown was felt across the board, it was industry that slowed most due to weak domestic demand, a relatively strong real exchange rate and the structural bottlenecks referred to earlier. The poor performance of industry was also mirrored in the decline of investment demand.

12. Recent data suggests that the recovery remains uneven and tentative. Growth surprised in the second quarter (1.5 percent), but was largely driven by transitional factors such as a strong soy harvest. It followed a much-slower first quarter (0.6 percent). On the demand side, fixed investment reported stronger growth in the first and second quarter of the year. Household consumption remained relatively robust despite concerns about its resilience in the face of higher inflation and rising indebtedness (the household debt to disposable income ratio rose from 30 percent in 2008 to 45 percent in June 2013).

13. Inflation remains at high levels. Headline inflation reached 6.1 percent in August. Non-tradable goods inflation remains very high at 8.4 percent. The high rate of inflation reflects in part the limited non-inflationary growth capacity of the Brazilian economy in conjunction with a

9 Leila Posenato Garcia, Lúcia Rolim Santana de Freitas, Gabriela Drummond Marques da Silva, Doroteia Aparecida Höfelmann, “Violência contra a mulher: feminicídios no Brasil” IPEA, September 2013

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long term infrastructure deficit, and a structurally tight labor market (due to skills mismatches and a receding demographic dividend). As a result, even at low rates of growth and with the support of relatively accommodative policy mix, demand-pull factors have played a key role. Cost-push factors such as automatic minimum wage adjustment have further amplified the inflationary pressure.

14. Fiscal and monetary policies were adjusted in response to slow growth and rapid inflation. Building on the credibility of Brazil’s three-pillared macroeconomic framework (flexible exchange rates, inflation targeting and fiscal prudence), in 2012 and early 2013 the authorities adjusted fiscal and monetary policy levers to support growth at the expense of a greater tolerance for inflation. The fiscal stance has been loosened with the primary surplus declining from 3.1 percent in 2011 to 1.9 percent in July 2013. However, with inflation hovering around the 6.5-percent upper limit of the inflation target range in the second quarter, monetary policy was tightened and the policy interest rate has been raised by 225 basis points to 9.5 percent between March and October 2013.

15. Concerns have emerged about the adequacy of the macroeconomic policy mix. Even though the fiscal stance remains fairly sound and debt remains under control at around two-thirds of GDP, fiscal indicators have deteriorated as discretionary tax incentives and slower growth lowered revenues and increased social demands put pressure on expenditures. The expansionary fiscal stance in turn generated additional need for monetary policy tightening in an environment where high and persistent inflation is already testing the credibility of the inflation targeting framework. In addition, the protracted economic weakness appears to have increasingly become a function of structural factors unrelated to the demand side and therefore limiting the effectiveness of the fiscal-monetary policy mix.

16. The emerging market sell-off mid-August served as a reminder of Brazil’s exposure to capital flow volatility. The Real fell 18 percent between April and August to 2.44 against the U.S. dollar, prompting a central bank intervention plan consisting of purchasing interest rate swaps and a foreign exchange repurchase program. By early October the cumulative intervention through repurchase operations had totaled $7.4 billion and has been highly successful in taming excessive exchange rate volatility. Much of the depreciation has since been recovered, with the Real trading now around 2.20. Overall foreign portfolio investments sustained a positive trend, and foreign direct investment remained strong with inflows of US$ 65 billion over the last 12 months (as of June). While the depreciation of the Real was externally induced, domestic factors have also contributed. These include uncertainty about the direction of economic policy, and investor disappointment arising from the slowdown of a previously fast-growing economy. Indeed this combination of factors led Moody’s to cut its view of Brazil sovereign debt from positive to stable in early October 2013.

17. Brazil’s financial system has remained sound and resilient. Following a period of rapid credit growth (with credit outstanding to the private sector exceeding 50 percent of GDP), asset quality indicators broadly stabilized during 2012 and recently reported some improvement. As of June 2013, around 7.2 percent of consumer loans and 3.5 percent of corporate loans were classified as non-performing. Lower interest rates have eased pressures on borrowers, keeping delinquencies at manageable levels. The banking system appears to be well-cushioned to withstand losses, with loan loss provision coverage at 160 percent of nonperforming loans and solvency ratios at 16.4 percent as of April 2013.

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Table 1 Brazil: Selected Economic Indicators and Projections (2006:2016)

2.1 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

18. The growth prospects for the Brazilian economy remain relatively muted, with 2.5 percent expected for 2013 and a gradual increase to 3.5 percent thereafter. As consumer confidence strengthens, consumption, which has remained relatively resilient – should get a boost from favorable fundamentals. Investment is expected to revive if sentiment improves, aided by the development of new offshore oil fields and the preparations for upcoming mega sporting events. Yet, the magnitude of the recovery of investment spending remains uncertain. The contribution of net external demand will likely remain dampened by structural factors affecting export competitiveness as well as the likely boost in import demand arising from domestic demand strength.

19. The inflation outlook is expected to remain a challenge, as the recovery takes a firmer hold. A key factor here is the role of the labor market which remains tight and rigid and may transmit into service price inflation.The labor market is characterized by low official unemployment (5.3 percent in August), scarcity of skilled workers in many sectors and labor hoarding due to low flexibility caused by structural issues affecting mobility and wage setting (such as indexation of the minimum wage to inflation and GDP growth). Government efforts to address skills gaps, including by scaling up vocational training, should help address some of these concerns in the medium term, although more will be needed to raise labor market flexibility. Other factors that may contribute to inflation include the pass-through of the recent

Indicator 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

National Accounts Real GDP Growth 4.0 6.1 5.2 -0.3 7.5 2.7 0.9 2.5 2.7 3.3 3.5

Gross domestic investment 16.8 18.3 20.7 17.8 20.2 19.7 17.6 18.1 18.6 19.0 19.3

External SectorCurrent account 13.6 1.6 -28.2 -24.3 -47.3 -52.5 -54.2 -76.1 -90.3 -96.6 -103.4

Merchandise trade balance 46.5 40.0 24.8 25.3 20.1 29.8 19.4 3.4 2.1 0.4 -1.8Exports (fob) 137.8 160.6 197.9 153.0 201.9 256.0 242.6 244.0 254.3 275.0 300.7Imports (fob) 91.4 120.6 173.1 127.7 181.8 226.2 223.2 240.6 252.2 274.6 302.5

Nonfactor services, net -9.6 -13.2 -16.7 -19.2 -30.8 -37.9 -41.0 -45.9 -53.4 -54.2 -57.3 Income and current transfers, net -23.2 -25.3 -36.3 -30.3 -36.6 -44.3 -32.6 -33.6 -38.9 -42.8 -44.3

Direct investment, net -9.4 27.5 24.6 36.0 36.9 67.7 68.1 60.0 60.0 73.5 77.5Portfolio equity, net 1 6.8 24.8 -7.3 39.7 43.9 16.0 3.3 3.4 3.5 3.5 4.2Gross international reserves 85.8 180.3 193.8 238.5 288.6 352.0 373.1 364.1 368.1 371.3 375.5Current account (% of GDP) 1.3 0.1 -1.7 -1.5 -2.2 -2.1 -2.4 -3.1 -3.5 -3.6 -3.6

General Government Total Revenues and Grants 34.6 35.7 36.9 34.9 37.2 36.6 37.2 37.0 36.8 37.1 37.2 Total Expenditure 38.1 38.4 38.2 38.0 39.9 39.1 40.0 39.2 39.2 39.5 39.4

Current Expenditure 36.2 36.6 36.0 35.8 35.9 36.7 37.5 36.6 36.6 36.8 36.7of which: Net Interest payments 6.8 6.2 5.5 5.2 5.2 5.7 4.8 4.4 4.8 4.9 4.7

Capital Expenditure 1.9 1.8 2.2 2.2 4.0 2.5 2.6 2.6 2.6 2.7 2.7 Primary Balance 3.3 3.5 4.1 2.2 2.5 3.1 2.1 2.2 2.4 2.5 2.5 Overall Balance -3.5 -2.7 -1.4 -3.1 -2.7 -2.5 -2.8 -2.2 -2.4 -2.4 -2.3 Gross Public Sector Debt 66.7 65.2 63.5 66.9 65.2 64.9 68.5 69.8 67.0 64.4 61.8

of which: Domestic Currency 60.0 60.6 58.4 63.2 62.1 62.2 65.4 66.9 63.8 61.2 58.6of which: Foreign Currency 6.7 4.6 5.1 3.7 3.0 2.7 3.1 2.9 3.2 3.2 3.2

Prices GDP Deflator 6.1 5.9 8.3 7.2 8.2 7.0 5.3 5.7 5.0 5.0 5.0 Consumer Price Index (eop) 3.1 4.5 5.9 4.3 5.9 6.5 5.8 5.8 5.8 5.3 5.0

Memorandum items: Nominal GDP (in R$ billions) 2369.5 2661.3 3032.2 3239.4 3770.1 4143.0 4402.5 5226.2 5668.1 6158.3 6691.0 Total External Debt (% of GDP) 17.8 17.5 15.9 17.4 16.4 16.2 17.9 18.5 20.2 21.0 20.4

Source: IMF, BCB, IBGE, EIU, WB Calculation

(in US$ billions, unless noted)

(in percent of GDP)

(annual percent change)

Note 1: Porfolio equity does not include debt securities

Projections

(annual real percent change)

(in percent of GDP)

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depreciation of the currency and also the end of restraint of administrated prices (fuel, energy, urban transport).

20. The external environment continues to pose a risk to Brazil’s outlook for near-term growth. Continuation of an uneven recovery in advanced economies and a slowdown in emerging markets including China, may translate into lower external demand for Brazil’s exports. External vulnerabilities also arise from the potential softening of the prices of commodity exports as this will affect the terms of trade and contribute to further pressures on the Real despite Brazil being a diversified exporter. Like other emerging market economies, Brazil also remains vulnerable to market sentiment posing a continued risk to FDI and especially portfolio flows, particularly given the relatively high share of Government debt held by non-residents (e.g. 65 percent in August for domestic fixed-rate bonds). Nonetheless, Brazil’s vulnerability to external events is likely to remain moderate due to its high reserves (US$ 367 billion), the low share of short-term debt in total external debt (around 18 percent), the large role of foreign direct investment (2.7 per cent of GDP in the year to July 2013) in financing the current account (-3.4 per cent of GDP in June 2013) and the relatively low degree of trade openness compared to other emerging markets.

21. The banking sector remains solid and well capitalized and would be vulnerable only in the case of a prolonged global and domestic slowdown. Most capital structure metrics suggest that the level and composition of private sector external debt pose no particular risks to stability of the financial sector at this stage. Overall, system-wide assessment of banks indicates that risks are well managed. Brazil’s banking system currently has solid liquidity levels, adequate capital cushions and the system’s direct exposure in foreign currency is limited. However, small and medium-sized banks, currently holding 8 percent and 12 percent respectively of the Banking system’s assets, are exposed to liquidity risk given their reliance on more volatile sources of domestic financing, while the larger banks, with greater access to external financing could face difficulties in rolling over external debt in the event of a major external crisis. Indeed, rising private sector external debt levels, largely reflecting increased issuance of bonds by corporates and banks, have raised concerns about the capacity of some companies to carry their debt.

22. Downside contingencies and social pressures for improved public services also pose risks to the fulfillment of Brazil’s fiscal targets. Should activity turn out more sluggish than expected, the achievement of primary surplus targets may be jeopardized, as federal revenues might decline and social protection expenditures might increase. Other potential fiscal risks include Government efforts to stimulate the economy through specific incentives for particular sectors, such as electricity and urban transport (hence the rising fiscal pressure), the subsidy to energy prices which is costing around R$ 20 billion for the federal budget in 2013, sporadic tax relief for selected industries, and quasi-fiscal activities by BNDES. More generally, social pressures for improved public services and mandatory payments for Congress Budget Amendments may also create stronger expenditure pressures. For example, demonstrations in June were followed by the announcement of a US$ 21 billion urban transportation package. Also, political tensions between Congress and the Executive Power as well as the coming election year pose further risks of pressures to the fiscal stance.

23. In spite of these risks and challenges, Brazil’s overall macroeconomic framework is currently adequate and sustainable in the medium term. Brazil’s policy framework continues to provide the Government with the flexibility to respond to economic crises with an array of fiscal, monetary, and external measures, while sustained political commitment to the broad objectives of inflation control and fiscal prudence has increased the resilience of the economy to

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external shocks. Gross public sector debt is expected to decline in the future, given the levels of the primary surplus, despite difficulties in maintaining fiscal balance in the face of large investment needs and popular pressures for improved service delivery. Moreover, flexible exchange rates and relatively large foreign reserves provide Brazil with a buffer to shifts in market perceptions and an associated turn-around in capital flows – as the recent episode of market turbulence has suggested. Finally the subnational fiscal framework provides a means of controlling the indebtedness of sub-national governments (see Box 1).

24. Brazil’s medium- to longer-term outlook will critically depend on its ability to tap into a large unrealized growth potential and remove structural bottlenecks. These bottlenecks include: the need to accelerate and strengthen the quality of human capital formation, reduce tax burden, increase the effectiveness of public spending, raise public and private investment to address growing infrastructure bottlenecks, developing a private long-term capital market, a more flexible labor market, and a more agile business environment that promotes internal competition and external competitiveness. Addressing these bottlenecks would lay the foundations for productivity growth. The authorities have begun addressing some of these challenges through increased focus on education, especially vocational training, the creation of infrastructure bonds, and the launching of a program of private-public partnerships in infrastructure. However, it is unclear if these efforts will be sufficient and effective in easing the supply constraints in the medium term.

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Box 1: Brazilian Fiscal Federalism and the Control of Sub-National Fiscal Performance

The fiscal stance of Brazilian states has always been an important element in macroeconomic management in Brazil. Until the late 1990s, the expansionary fiscal policies by the States and the lack of effective controls over their indebtedness resulted in frequent sub-national debt crises. On three different occasions (1989, 1993 and 1997) the Federal Government had to take on and reschedule the debts of the States. The largest operation occurred in 1997, when the Federal Government restructured R$200 billion (12 percent of national GDP) of the debts owed by the States. In the 1997 refinancing operation, the debts were refinanced for 30 years. The 1997 bailout was conditioned upon the State’s compliance with medium-term fiscal adjustment and structural reform programs (three-year rolling PAFs) to be agreed between each State and the National Treasury Secretariat. The PAFs set annual targets on indebtedness, primary balances, personnel spending, tax revenue and public investment, in order to guarantee a gradual decline in indebtedness. In addition, the PAFs include structural reforms such as privatization or other public sector modernization initiatives.

The controls on sub-national fiscal performance were further strengthened by the approval of the Fiscal Responsibility Law (Lei de Responsabilidade Fiscal—LRF) in 2000. The LRF institutionalized fiscal discipline at all levels of government, incorporating hard budget constraints into a single unifying framework. It explicitly prohibits debt refinancing operations between different levels of government, thereby addressing the moral hazard problem in intergovernmental fiscal relations caused by sequential bailouts. Complementary Senate resolutions also prohibit borrowing if: (i) the net consolidated debt exceeds twice net current revenue (Receita Corrente Líquida – RCL)) (ii) new credit operations exceed 16 percent of RCL; and (iii) debt service exceeds 11.5 percent of RLC. Borrowing is also prohibited if it violates the debt reduction schedules set by the debt renegotiation contracts. Finally, as per a resolution from the Federal Senate, issuance of sub-national governments bonds is prohibited through 2020. This system of controls has resulted in repeated state and municipal surpluses. In addition, this system has also favored the adoption of appropriate expenditure programs by sub-national governments.

Besides the controls on indebtedness, LRF requirements improved transparency and strengthened budgetary practices. Budget outturns and compliance with the LRF —including a statement of corrective measures if the relevant provisions are breached—are reported on a regular basis. Municipalities and states are also required to report the fiscal outturns of the previous year to the Ministry of Finance.

The LRF also introduces more stringent requirements on fiscal targets in the preparation of the Budget Guidelines Law, strengthening its role in budget preparation and fiscal management in general. The LRF also calls for a detailed assessment of the Government’s contingent liabilities. A complementary Fiscal Crime Law is applied to all levels of the public administration, with the possibility of detention for those public officials not complying with the LRF.

Recent Supreme Court (Supremo Tribunal Federal – STF) rulings affected both intergovernmental transfers and ICMS, are forcing Congress and the States to change the current subnational fiscal framework. The debate on the new oil exploration regime has also prompted the legislative to change the oil royalties sharing scheme. Finally, states and certain municipalities are lobbying for a renegotiation of the terms of the debt they owe to the Federal Government.

2.2 RECENT ECONOMIC DEVELOPMENTS IN RIO DE JANEIRO

25. Following years of stagnation, the economy of the State of Rio de Janeiro saw more rapid and robust growth up to 2010. The economy grew at an average 2.9 percent over 2002-10. In 2010, the last year for which data is available, growth registered 3.6 percent. Rio de Janeiro remained fairly resilient during the global financial crisis, posting 2 percent growth while the national economy contracted by 0.3 percent in 2009. While manufacturing and construction at the time were significantly affected (shrinking 8 and 4 percent, respectively), services remained resilient and the growing oil industry provided support.

26. While services – especially financial services and tourism – have continued to dominate to economy of Rio, the resurgence of the economy was driven in large part by rapid industrial growth, particularly in the oil industry. This followed the opening of the sector to private investment in 1997 and the exploration of oil fields in the Bacia de Campos. It led to the revitalization of industries that rely heavily on petroleum and had a positive impact throughout the economy, including creating an important source of fiscal revenue through

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royalty payments on oil production. Currently, the State accounts for about 75 percent of Brazilian oil production and the oil industry accounts for 35 percent of industrial production in the State. These developments have led to a surge of the share of industry in GDP to 28 percent over the last 10 years.

27. Recent indicators however point to a significant economic slowdown since 2011. While State GDP figures are not yet available for 2011 and 2012, it is clear that economic growth has slowed considerably. Industrial production has been fairly stagnant since 2010, growing at an annualized rate of less than one percent between end-2010 and July 2013, well below the national performance of 3.5 percent. The low growth of industrial production over this period was driven by a sharp drop in extractive industries (-7.7 percent) which was balanced by growth in manufacturing of 2.9 percent, still below the national level of 3.7 percent (all average annual growth rates since end-2010). In addition, retail sales – a traditional source of resilience – have slowed, from 6.8 percent in 2011 to 4.1 percent in 2012 and 4.4 percent in 2013 (first 7 months compared to same period previous year).

28. Underpinning Rio’s strong performance between 2004 and 2010 was the robustness of job creation in the formal sector. Since 2004 the State has gained more than 1.2 million formal jobs, an average annual rate of more than 130,000. However, the average wage of workers did not grow as fast as in other States. One possible explanation is that the jobs being created are mostly in the service sector and tend to pay low wages. The unemployment rate in the Rio metropolitan region is at about one percentage point below the national average and has been decreasing in recent years despite a brief hike in 2011.

29. Rio de Janeiro is heavily reliant on ICMS taxes, oil royalties10 and transfers. These three revenue groups constituted 89 percent of the total revenue in 2012, with taxes accounting for two thirds of all revenues, while royalties accounted for 15.5 percent and transfers for 7 percent. Tax revenues are derived mainly from ICMS (VAT on goods and services). The State of Rio de Janeiro being responsible for 75 percent of the oil production in Brazil, it also receives under the current oil royalties sharing rule the largest revenue share.

30. Investment expenditure pressures have increased, notably in preparation for the World Cup and Olympics that Rio will be hosting in 2014 and 2016. Transport and urban development, which were required to fill the infrastructure gap in the State, have been accelerated due to the sporting events. While investment has been the fastest growing expenditure since 2008, payroll expenditures have also almost doubled (in nominal terms) in the same period. Pressures also stem from on-going commitments in security, personnel, and health.

31. In this context, the primary balance has turned into deficit, but Rio de Janeiro has remained in compliance with the Fiscal Responsibility Law targets. The State has reduced its relative debt through fiscal adjustment (particularly improving revenue administration) since 2007, while simultaneously undertaking a major program to raise investment. Nevertheless in 2012 for the first time in many years the primary balance became negative, approaching R$ 1 billion. However, the ratio of Net Consolidated Debt (NCD) to Net Current Revenues (NCR) has remained under the 200 percent threshold, reaching 155.4 percent in April of 2013. The limit on the value of guarantees given, which is 22 percent of NCR, has also been abided with. The value of the outstanding guarantees has remained under 6 percent of NCR since 2004. Lastly, consolidated personnel expenditures amounted to R$ 15.8 billion in 2012, which corresponds to 39 percent of NCR, well below the 60 percent limit. 10 The State of Rio de Janeiro classifies royalties as own source revenues rather than transfers.

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2.3 MACROECONOMIC OUTLOOK FOR RIO DE JANEIRO

32. Rio de Janeiro’s economy has considerable potential, but decisive policy action will be required to tap into the opportunities. The oil and gas industry, an important driver of economic growth over the last decade, is expected to continue growing with the exploration and start of production in the giant Pre-Salt fields. This should present opportunities to expand associated industries up-stream and down-stream such as petrochemicals (Comperj) and ship building which is being revitalized. Finally, the upcoming mega sports events are propelling accelerated investments in physical and social infrastructure, laying the foundations for higher State growth in the future. However, policy action will be needed to enhance the competitiveness of the State and make it an attractive location for industry and services. Major challenges include transportation infrastructure, public education, public health and security.

33. Looking ahead, the fiscal position of Rio de Janeiro is considered to be generally sound and sustainable despite expenditure pressures. The overall fiscal policy objective of the SRJ in recent years has been to generate and maintain positive budget balances. This has created the fiscal space needed to accommodate higher investments and start improving the quality of service delivery for the poorest communities. The forecast indicates that the State will achieve a positive gross operating balance, but will face important financing needs due to its heavy investment program. The primary balance will remain negative until 2016 but will gradually improve (from -7.2 percent of NCR in 2013). In relation, the overall conclusion of the debt sustainability analysis, described in detail in Annex 4, is that the upcoming sporting events will be associated to a temporary rise in the debt until 2015, reaching 194 percent of net revenues under the conservative baseline scenario (15.4 percent of State GDP); however this will not pose a threat to long term sustainability as the Government maintains its fiscal policy stance of restoring primary surpluses to reduce debt levels.

34. Rio could also suffer a significant loss from the proposed change in the oil royalties sharing scheme. The new law has not been put into effect due to an injunction issued by the Supreme Court at the request of three states (including Rio). The changes in the ICMS that are also being discussed would benefit Rio, but would only partly compensate for the loss in royalties and are less likely to materialize.

35. The change in the royalties sharing scheme would represent an average loss of 7 percent of NCR compared to the baseline scenario. Nevertheless it is recognized that even if this were to occur, some offsetting mechanisms would almost certainly be put in place (in terms of transfers from other pooled resources). Thus, the Debt Sustainability Analysis (Annex 4) includes an alternative scenario in which the State loses the equivalent of half of its revenue from royalties over the projection period. Without other adjustments, this would translate into a worsening of fiscal balances throughout the period, with both the gross operational balance and the primary balance becoming negative during the period 2014-17. The level of debt would exceed 200 percent (reaching 215 percent of NCR, or 16.1 percent of State GDP).11 In light of its good record of sound fiscal management, the State would likely respond by containing expenditures, particularly from 2016 onwards, so as to put debt on a downwards path. In addition, due to the LRF rules, the State would not be able to contract any new loans while its

11 While this value is formally above the LRF limit of 200 percent, it would not imply any sanctions by the Federal Government, since loans contracted for the purposes of financing infrastructure for the World Cup and Olympic Games have been deemed not to count for the purposes of sanctions under the LRF.

12

debt to revenue ratio is above 200 percent, constituting thus another downward driver on the debt trajectory.

Table 2– Effects of change in royalties revenue distribution on fiscal projections: 2013-2017, (R$ Billions)

Sources: IGBE and World Bank Calculations

36. In addition to the analysis of the impact of a loss of royalties, an analysis was made of a number of alternative potential adverse impacts on the fiscal position of the State of Rio de Janeiro. These are: i) lower growth, ii) higher investment requirements, iii) higher wage bill, and iv) revenue shock. The scenarios are described in detail in Annex 4. All imply somewhat higher levels of debt in the short term, with the low growth and revenue shocks raising debt to a maximum of 215 percent of net revenue (16.1 percent of State GDP), while debt begins to decline subsequently as the State is able to return to its fiscal objective of maintaining a primary surplus and managing expenditures so as to ensure a downward trajectory for the debt. A worst case scenario was also explored in which the royalty shock is combined with the growth and investment shocks. This does indeed imply debt increasing to over 240 percent of Net Revenues (18 percent of State GDP). A worst case scenario should be seen as unlikely but not impossible. However the Government of Rio de Janeiro has shown its capacity to manage fiscal policy well, and to make the necessary adjustments to correct the debt path.

37. In conclusion, the SRJ’s expenditure program and fiscal arrangements between the Federal Government and the SRJ are adequate for the purpose of this operation, and the SRJ’s debt has been assessed as sustainable, although not without risks in a very adverse environment.

2.4 IMF RELATIONS

38. Since the International Monetary Fund (IMF) does not work directly with state governments there has been no direct collaboration with the IMF on this specific operation. However, the Bank and Fund teams work very closely on the overall Brazil program. This is consistent with the Joint Management Action Plan (JMAP), which, in order to improve coordination at the country level, calls for Bank and Fund staff to consult at least annually in the preparation of their work programs. Brazil country teams from the Bank and the Fund have also been meeting regularly.

3. THE GOVERNMENT’S PROGRAM

39. The GORJ seeks to ensure that any program put in place is fiscally sustainable; thus guaranteeing that the objective of improving public service delivery goes together with the creation of fiscal space for investment. In this account, the State Secretariat of Finance (SEFAZ) has been putting increased emphasis on the efficiency of public spending. In parallel, the Government has undertaken several reforms in public finance management and service

2013 2014 2015 2016 2017 2013 2014 2015 2016 2017

Revenues 57.4 62.8 65.1 71.9 78.7 57.4 61.2 62.9 68.9 74.8

Expenditures 56.2 61.3 65.1 70.9 74.9 56.2 61.3 65.1 70.9 74.9

Gross Operating Balance 1.1 1.4 0.0 1.0 3.7 1.1 ‐0.2 ‐2.2 ‐2.0 ‐0.1

% of NCR 2.6 3.0 0.0 1.8 6.3 2.6 -0.4 -4.7 -3.9 -0.3Primary Balance ‐3.1 ‐2.9 ‐2.8 ‐0.8 2.6 ‐3.1 ‐4.5 ‐4.7 ‐3.3 ‐0.8

% of NCR 2.6 3.0 0.0 1.8 6.3 2.6 -0.4 -4.7 -3.9 -0.3Overall Balance 0.7 1.7 ‐0.9 ‐2.4 ‐0.8 0.7 0.2 ‐2.9 ‐4.9 ‐4.2

Debt 75.7 85.6 95.6 104.1 109.1 75.7 87.1 99.2 110.4 119.2

% of NCR 175.1 181.1 194.3 191.5 183.1 175.1 190.8 211.1 214.9 213.9% of State GDP 14.7 15.0 15.4 15.2 14.5 14.7 15.3 16.0 16.1 15.8

Baseline Scenario With change in Royalties

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delivery with a focus on two key services: (i) urban mobility services in the RJMR; and (ii) social services to address domestic and gender-based violence.

Public Financial Management (PFM) and Budgeting

40. Since 2007, the GORJ has implemented and perfected several reforms to strengthen public finance management and enhance fiscal discipline for improved fiscal sustainability and service delivery. Government agencies have been given financial quotas and intra-year budget limits to guarantee that their expenditures remain within the authorized budget. The GORJ has also undertaken an important modernization program for the State Treasury aiming to reduce operational risks associated with weak procedures and low capacity. 12 Fifteen products under the responsibility of the Treasury have been identified and submitted to a standardization and quality management process following the International Organization for Standardization (ISO) methodology. Processes have been redesigned, manuals have been drafted, and public employees trained.

41. To improve multiyear planning and budgeting, the GORJ has also started moving to a Medium-Term Expenditure Framework (MTEF), with the introduction of pilot costing of budget programs and an assessment of medium-term budgetary implications of capital expenditures. Finally, the GORJ has also taken some steps to improve the appraisal of Public Private Partnership (PPP) projects. A simple manual was issued by the Government in 2008. More recently, a dedicated group was established under the State Treasury to evaluate the technical and economic viability of PPPs with an established procedure under the ISO methodology.

Urban Mobility Program

42. Since taking office in 2007, the current Government has made important advances to improve the quality and availability of urban mobility services. The GORJ’s urban mobility agenda is articulated around a massive investment program and a range of important policy and institutional reforms to improve the efficiency, affordability and inclusiveness of urban transport services:

The government has been carrying out a large capital investment program (US$7.5 billion) that leverages private sector resources and expertise to improve urban mobility in high-poverty areas: With Bank support, the State has invested in new rolling-stock (financed under the Mass Transit and Upgrading and Greening Urban rail projects) to improve the quality of service of the urban rail system known as Supervia. This is a 225 Km. system operated under a PPP, which serves low-income areas in the RJMR. The State has also developed a new cable car system (Teleferico), constructed and now operated by the same private sector operator that manages Supervia. The Teleferico began operating in July 2011, with an extension of 3.5 Km. and 152 gondolas with the capacity to carry 10 passengers each. The Teleferico serves a group of low-income communities known as the Complexo de Alemão, and charges a differentiated, low tariff for the residents of these communities.13 In addition the State is currently investing in the development of Metro Lines 3 and 4. Finally, the state is also investing in projects that

12 Operational risk is defined as the possibility of losses caused by deficiencies of internal processes, staff, systems and external events. 13 The system’s tariff for community residents is R$ 1 (R$ 5 for visitors), but each resident is entitled to two free tickets per day (round trip), a social benefit granted by State Law. The R$1 rate is significantly lower than that for other transport modes, which range between R$ 2.75 for city buses to R$ 3.10 for the Metro

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enable the integration of the rail system with other modes at key stations. In parallel, the MRJ is investing on the development of Bus Rapid Transit (BRT) systems with a total extension of more than 150 km of exclusive bus ways, which together are expected to mobilize over one million passengers per day.

The Government has designed and is implementing a range of policy and institutional measures aimed at complementing infrastructure investments to enhance urban mobility services. This reform program features in particular the development of Non-Motorized Transport (NMT) as an element of intermodal integration: The GORJ has instituted the Programa Rio-Estado da Bicicleta to promote walking and cycling by supporting municipal bike lanes and bike parking projects and making bicycles available to mass transit users. Furthermore, the government has started implementing new inter-municipal bus concessions to replace the current permissions that are expiring at the end of 2013. In parallel, an integrated fare scheme (bilhete único intermunicipal) has been introduced to improve affordability of urban mobility services. This scheme, in which the Government of the SRJ pays operators the residual value of the fare to make them whole, reflects an important policy advance for affordability.

The Government is now working on the development of an updated Urban Transport Master Plan (PDTU), which will serve as a foundation for further regional and modal integration of urban transport systems in the RJMR.

Program to improve the delivery of services addressing Domestic and Gender-based Violence

43. In 2007, the GORJ created the Women Rights Administration (Superintendencia de Direitos da Mulher - SUDIM/RJ) within the State Secretariat for Social Welfare and Human Rights (SEASDH). SUDIM/RJ worked on raising awareness on pressing gender issues, mobilizing civil society, running information and limited service programs and developing and consolidating a State and municipal network of gender focused support services and practitioners. However, the lack of resources limited the impact and results of these efforts. In February 2013, SUDIM/RJ was replaced by a new Sub-Secretariat of Policies for Women (SPM-RJ) as a way to increase the capacity of action and flexibility to deliver state services. SPM-RJ is in charge of (i) liaising with different departments of the three spheres of government – federal, state and municipal -- and with civil society organizations, with the aim of ensuring the implementation of existing gender policies; (ii) developing policies for the elimination of all discrimination against women; (iii) supporting women in situations of violence and discrimination through the existing “Integrated Centers for Assistance to Women”; (iv) coordinating training for women within the network of State support services; and (v) advising women in situations of violence and discrimination through a “free hotline”. The SRJ has also put in place various resources to provide targeted assistance to women in situation or risk of violence.14

14 including: 31 “Reference Centers for Assistance to Women” (Centro de Referencia de Atendimento a Mulher –) of the Special Secretariat of Human Rights (Secretaria Especial dos Direitos Humanos); 12 “Special Police Stations for Assistance to Women” (Delegacias Especiais de Atendimento a Mulher”) of the Division of Services to Women of the State’s Civilian Police; 11 “Courts for Domestic and Family Violence Against Women” (Juizado da Violencia Domestica e Familiar Contra a Mulher) of the State Secretariat for Justice; and 1 “Judicial Center for Temporary Shelter of Women Victims of Violence” (Central Judicial de Abrigamento Provisorio da Mulher Vitima de Violencia Domestica).

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4. PROPOSED OPERATION

4.1 LINK TO GOVERNMENT PROGRAM AND OPERATION DESCRIPTION

44. The proposed DPL is part of a broad World Bank engagement with the Government of the State of Rio de Janeiro (GORJ). The proposed operation is also part of a larger GORJ sectoral reform program of US$750 million. The World Bank will finance US$500 million through the proposed single-tranche DPL. The remaining balance of the GORJ program is expected to be financed from other sources, including a potential combination of MIGA instruments, bilateral donors and/or the private sector. The total loan amount of US$500 million will be disbursed once the operation goes into effect, contingent upon the State’s maintenance of an adequate macroeconomic policy framework, and the State's maintenance of an appropriate expenditure program, sustainable debt and appropriate fiscal arrangements with the Federal Government.

45. The PDO is to assist the GORJ in its efforts to enhance public management for the delivery of key public services for vulnerable populations by instituting new policies and regulations to improve: the medium term planning and monitoring of public expenditures (Policy Area 1); the accessibility, quality and affordability of urban mobility services for the poor (Policy Area 2); and the availability of targeted social services aimed at reducing domestic and gender based violence (Policy Area 3). This objective directly contributes to poverty reduction and shared prosperity, as financially-sustainable and targeted urban mobility and social support services benefiting the poor and vulnerable populations, enable more equitable access to economic and social opportunities, allowing the benefits of growth to be shared more widely.

46. The PDO is linked to the GORJ’s priority of improving the availability and quality of public services, an objective that has become even more critical following the recent demonstrations in Rio de Janeiro and across Brazil. Specifically, the operation will support reforms that seek to improve the delivery of transport and gender-focused social services of the State in a financially sustainable manner, as a response to growing citizen demands and fiscal discipline requirements. As discussed in the introduction section, urban mobility and social services for women are fundamental for improving the lives of vulnerable segments of the population in the SRJ.

47. Under the first policy area, the proposed operation supports a program aimed at institutionalizing a series of sound PFM practices that will help consolidate fiscal space and enhance efficiency in government expenditures – a necessary precondition to maintaining financial sustainability, while continuing to improve service delivery.

48. Under the second policy area, supported reforms will complement government’s investments in the transport sector to improve the delivery of mobility services. Specifically, the policy actions supported by the operation are aimed at: (i) developing an integrated multimodal metropolitan transport system under the umbrella of a master plan that can eventually become the planning tool of a metropolitan transit authority and the basis for civil society involvement; (ii) improving the quality and productivity of inter-municipal bus services through modern concessions, awarded to competitively selected private operators that are remunerated based on performance indicators measured through real time data also available to users; and (iii) consolidating the current affordability / social policies which support access to transport services for the most vulnerable populations by ensuring that these policies are financially sustainable. These reforms will directly and significantly help the poorest residents of the RJMR – improving

16

quality of service, reducing travel times and ultimately improving affordability of public transport.

49. Under the third policy area, the proposed operation will back ongoing efforts in the RJMR to improve the delivery of gender-focused services and reduce domestic and gender-based violence by supporting the implementation of the “Lei Maria da Penha”. Transport infrastructure will be used as a platform for delivering information and social support services that had been previously constrained by limited resources for deployment. This reform is expected to stimulate the mainstreaming of initiatives that maximize the role of the region’s transport infrastructure in addressing a broader social agenda.

50. The operation’s policy matrix includes a limited number of prior actions that have been chosen according to their criticality in achieving results and in close cooperation with the client. This follows good practice principles on conditionality learned in previous DPLs, such as (i) need for reinforcing ownership among State and Federal governments’ involved stakeholders, (ii) agreement up-front with the Government and other partners on a coordinated accountability framework summarized in a brief and focused policy matrix, (iii) customizing the accountability framework and modalities of Bank support to address country circumstances reflecting the State’s priorities, backed by comprehensive analytic work, (iv) choosing only actions critical for achieving results as conditions for disbursement, and (v) close and regular engagement of the team with the State (including during supervision) to ensure that expected progress is achieved.

4.2 PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS

Policy Area 1: Instituting policies to improve medium-term planning and monitoring of public expenditures

Policy Objective 1.1: Adopt sound financial and debt management policies and practices

51. SEFAZ’ efforts to institute a policy to address operational risk in the State Treasury have been transformational, but they now need to be institutionalized and given a legal basis. The new procedures are well embedded in the organization, especially because new public employees, who were hired through competitive exams, have been trained under these new procedures. Thus all elements for the policy to become institutionalized are present: culture, norms, and behavior. However the operational risk policy still lacks a formal legal basis, laying it open to reversal in the future.

52. Similarly, successful PFM practices have been implemented by the State since 2007. However they are still subject to annual reauthorization. The GORJ is mandated to follow these policies because every year a decree is issued reinstating them. In order to ensure the sustainability of these practices, these PFM measures need to be given a more permanent legal basis.

53. Prior Actions. The State has taken the following actions to adopt sound financial and debt management policies and practices:

The State has adopted the legal framework to implement its treasury’s operational risk policy, which policy provides for, inter alia, mandatory disclosure of related documents on the internet and the State’s submission to yearly external audits of said policy, as evidenced by the State Decree n. 44.428 issued on 10/11/2013 (Prior Action #1); and

The State has established the legal basis for the use of sound financial and debt management tools, such as budget and financial quotas, minimum and average cash

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balance, and procedures for making payments to its suppliers, as evidenced by the State Decree n. 44.429 issued on 10/11/2013 (Prior Action#2);

54. The expected results of these prior actions are the following:

Maintenance of the number of events (occurrences and non-conformities) in which the operational risk policy procedures were not complied with within already achieved satisfactory levels. Baseline= [occurrences = 52; non-conformities = 12] (2012); Target = [occurrence = 48; non-conformities = 11] (2014)

Reduction in the number of times in a year that the actual cash balance has remained below the minimum threshold (set at 1.5 times the payroll amount). Baseline= 3 out of 12 (2012); Target = 2out of 12 (2014)

Reduction in the percentage of payments made after 30 days. Baseline= 3.6% (2012); Target = 3.0% (2014)

Policy objective 1.2: Strengthen the definition of the budget resource envelope under a Medium-Term Expenditure Framework (MTEF)

55. The State does not currently undertake multi-year revenue forecasting, and no hard budget constraint is imposed on line Secretariats. SEFAZ has taken initiatives to improve the definition and management of the budget envelope, including improvements in revenue forecasting and the production and publication, every two months, of an updated estimate of available resources (a good practice from the Federal Government).

56. Prior Actions. The GORJ has launched reforms to strengthen the top-down approach to budget preparation through improved procedures for estimating the resource envelope and defining sector ceilings. Specifically, the operation will support the following prior action:

The State has adopted the following budget preparation practices to improve its accountability and fiscal discipline: (A) preparation, publication and regular updating of detailed revenue estimates including subsequent years’ estimates; and (B) issuance of an annual budget directive setting appropriate sectorial budget ceilings which shall be consistent with the medium term revenue forecasts and targets for public indebtedness, as evidenced by State Decree n. 44.431 issued on 10/11/2013 (Prior Action#3)

57. The expected results of these prior actions are the following:

Reduction in the gap between actual and estimated revenues, measured as a share of estimated revenues. Baseline= [6.6%] (average 2010-2012); Target = 5% (2014)

Publication in the internet of revenue estimates documents for the 2014 budget. Baseline= No (2012); Target = Yes (2014)

Annual Budget directive issued for the 2015 budget cycle. Baseline= N.A (2012); Target = Yes (2014)

Policy Objective 1.3: Implement a framework to deal with fiscal commitments originated from Public-Private Partnerships (PPPs)

58. PPPs are an effective way to muster private capital to finance hard and social infrastructure and promote efficiency gains in public service provision. However, fiscal implications of PPPs, including associated contingent liabilities, need to be properly identified and monitored. The State of Rio de Janeiro has just signed its first PPP contract, for the operation and maintenance of the Maracanã sports arenas which will be used for both the World Cup and the Olympics. Acknowledging that PPPs are a source of fiscal risk, the Government of SRJ has

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decided to properly integrate PPPs into an MTEF approach to avoid undermining budget credibility. Thus, the intent is to develop a comprehensive framework to identify and manage all fiscal commitments associated to PPP contracts, be they explicit or contingent in nature, for both signed PPP contracts, and projects in the pipeline. This framework will be updated regularly during the year. In addition, such information is expected to be made public with a twofold objective of preventing unbudgeted expenditures and giving reassurance to investors that their public partner can afford such projects.

59. Prior Actions. The Borrower has taken the following action to implement a framework to deal with fiscal commitments originated from PPPs, supported by the proposed operation:

The State has adopted the following institutional practices to improve its transparency and accountability: (A) regular publication of a comprehensive estimate of fiscal commitments, including explicit and contingent payments from effective and prospective PPP contracts, which estimates shall be updated at least annually together with the annual budget law; and (B) publication of all documents and analysis relating to PPP projects through a specialized website, as evidenced by State Decree n. 44.430 issued on 10/11/2013 (Prior Action #4).

60. The expected results of these prior actions are the following:

A comprehensive report including current and prospective long-term commitments and liabilities from PPPs is published as scheduled. Baseline= No(2012); Target =Yes (2014)

All PPP-related bidding documents, contracts and supporting analysis are published on a dedicated website in a timely manner Baseline= No (2012); Target = Yes (2014)

Policy Area 2: Instituting policies and regulations to improve the accessibility, quality and affordability of urban mobility services for the poor

61. The efficiency and productivity of the mobility system, and the degree to which it is affordable and integrated, will be key determinants of the RJMR’s ability to continue to grow and prosper and develop in a manner that facilitates social inclusion and shared prosperity. The current combination of inadequate service quality and high costs associated with urban mobility present a serious constraint on the region’s productivity. The infrastructure investments underway could make a significant difference to ameliorate the situation. However, a set of complementary reforms is needed to realize the potential of these investments and relieve the region’s serious problems with mobility and inequality.

Policy Objective 2.1: Foster modal and regional integration in urban transport systems

62. Effective integration among different transport modes (rail, bus, non-motorized and ferries) and across regional and urban systems (systems managed by different levels of government) is fundamental to improve the efficiency of capital investments and reduce negative externalities, such as pollution and congestion. Nonetheless, options for strong regional integration at the metropolitan level are limited by the formal independence across levels of Government established in the Brazilian Constitution of 1988. The constitution assigns different responsibilities to federal, state and municipal governments. Nevertheless, there is some overlap in the management of metropolitan transport. Municipalities control municipal bus routes, parking, land development regulations and local roads. The State is in charge of regional transport modes, such as the Supervia, inter-municipal buses and the ferry, and the Metro. In Rio de Janeiro, the MRJ is developing a BRT network that overlaps in some sections with state-managed systems. With Bank support, the State created a Regional Transport Coordination Commission involving the municipalities, operators and users (Agência Metropolitana de

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Transportes Urbanos -AMTU). Nonetheless, AMTU only functions as a forum for discussion of metropolitan policies for prices and subsidies as well for discussion of common issues such as the integrated fare scheme and major investment projects for the RJMR, but it lacks formal power.

63. In practice, while the urban mobility sector has seen significant levels of regional coordination in recent years, there is a need to consolidate and institutionalize this process more formally. The Metropolitan Urban Transport Plan (PDTU) that is currently being updated and that will be launched prior to the end of 2013 needs institutional standing so that future governments (at the state and municipal levels) have to define their priorities within a consistent policy framework, going through a consultative process to validate those priorities. Similarly, in terms of implementation, while the planning process for the Olympics has seen successful coordination – these efforts are still ad hoc and need institutionalization.

64. From an intermodal perspective, the most important challenge is to integrate bus lines (state and municipal) with mass transit infrastructure. In principle, inter-municipal bus operators choose routes and the State ‘approves them’. However, in practice, the State has little ability to control and influence routes once established, and there are many routes that compete directly with regional state-managed infrastructure, such as Supervia, metro and the ferry system. Moreover, there is little integration as most suburban rail stations do not have adequate bus transfer facilities and inter-municipal buses do not have incentives to facilitate inter-modal integration.

65. Improving NMT to provide ‘last-mile’ access is another critical element for fostering intermodal integration. Although the investments that the State has made in bicycle parking are important, experience suggests that in order to effectively mainstream the role of bicycles and realize their potential, there is a need to systematically assess and address the barriers to cycling around major transit stations. The development of NMT is also often limited by the lack of quality, safe and well-connected cycling networks. However, many of the small municipalities in the periphery of the region do not have the institutional, technical and financial capacity to undertake a systematic review of constraints to NMT and implement related actions.

66. Prior Actions. The State has taken the following actions to foster modal and regional integration in urban transport systems:

The State has: (A) adopted the Urban Transport Master Plan (PDTU) as the policy framework for the planning and development of an integrated transport system in the RJMR; and (B) established a formal coordination mechanism to enable the State, the academia, civil society institutions and RJMR municipal governments to participate in the implementation of the PDTU, as evidenced by State Decree n. 44.433 issued on 10/11/2013 (Prior Action #5).

The State has taken a first step to initiate the implementation of a policy to physically integrate municipal and state-managed mass transit systems in the RJMR, as evidenced by the Memorandum of Understanding entered into between the State and Supervia (rail operator) for the implementation of multimodal integration projects, dated 08/22/2013. (Prior Action #6).

The State has adopted a new policy to promote non-motorized transport (NMT) through which it will: (1) ensure that secured bicycle parking will be available at all major transit stations in the RJMR; and (2) provide technical assistance to RJMR municipalities in developing high quality NMT access to major public transport stations, as evidenced by SETRANS Resolution n. 1.114 issued on 10/10/2013. (Prior Action#7).

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67. The actions supported by the DPL are expected to: reinforce and institutionalize the emerging culture of coordination between municipal and state governments; solidify the practice of conducting investment planning informed by data and analysis contained in the PDTU; and set the stage for enhanced regional integration of transport systems, including non-motorized modes. By the end of the operation (December 2014 ), the following key targets are expected to be achieved:

The Permanent Committee for the implementation of the PDTU, involving relevant government and civil society actors, meets at least four (4) times in its first year of existence and presents a strategy for the implementation of at least one (1) priority project in the area of urban transport integration under the PDTU. Baseline= Formal committee to accompany implementation of the PDTU does not exist (December 2013) / Target =4 meetings and 1 PDTU project discussed (December 2014).

No transport project outside of the PDTU (i.e. not endorsed by PDTU) will be undertaken by the GORJ.

At least one (1) multimodal integration project, connecting state and municipal transit systems, is completed Baseline = 0 / Target = 1 (December 2014).

State prepares guidelines for the development of bicycle-public transit integration projects to be implemented by metropolitan municipalities and at least one (1) of these projects is implemented with the State’s technical assistance. Baseline = 0 projects / Target = 1 project (December 2014).

Policy Objective 2.2: Enhance the performance and transparency of inter-municipal bus services

68. Inter-municipal and municipal bus services account for a large share of trips in the metropolitan region and recent protests have highlighted the challenges related to bus services and public transport tariffs in Rio and other Brazilian cities. In 2012, in the RJMR, approximately 8.5 million trips (38 percent) were carried on buses, of which about 1.8 million (7.5 percent) correspond to 604 inter-municipal routes operated by approximately 5,700 vehicles Bus services are often associated with congestion on city roads, inconsistent quality and non-transparent governance structures. Incumbent operators have significant financial and political strength; do not compete for their routes; and usually do not face competition within their core zone of influence. At the same time, there is an oversupply of buses on some key corridors, such as corridors linking the MRJ to the rest of the region. The performance and governance of bus services were a central catalyst for the protests that took place in June 2013 in Rio and across Brazil.

69. There is a widespread perception that the current system of regulation serves the operators better than it serves the users. Operators are free to propose route configurations within their license, to be approved by the State’s Road Transport Department (DETRO), and there is little or no integration with non-bus modes. Fares are high, relative to international references, and the variables that determine tariff-setting are not public: according to the State Decree that regulates inter-municipal passengers transport, DETRO is responsible for setting the tariffs ‘taking into account costs and fair capital remuneration’. As is often the case with a cost plus based regulatory regime, the current mechanism incentivizes companies to focus on investments that increase their cost base (such as quality of buses). No system is in place to measure performance of service providers, foster service improvements or lower costs. Anecdotal evidence suggests that buses often do not perform in terms of service delivery: frequency, punctuality or reliability. There is no incentive to take actions that would benefit the

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system as a whole, such as integration with the core regional transport system (rail, metro and ferries) or to focus on initiatives that could enhance productivity (such as on-street bus priority).

70. The GORJ has undertaken to implement an alternative vision for modern bus services, around regulated concessions where government designs routes, oversees a competitive concession process, and institutes performance-management of bus operators The key element of such a transformation requires a process to ensure open and competitive bidding for inter-municipal bus lines, and the design of a public information system that discloses bus contract costs and performance indicators for all metropolitan transport services. The fundamental objective is to enhance competition and transparency for improved bus service delivery by creating a new performance-based model for the selection and management of bus service operators. This model will build upon a monitoring system (part of the State’s Intelligent Transport Systems-ITS Plan15) that generates the operational data required to measure quality and productivity in an open and transparent manner.

71. There is a concurrent need to amplify the involvement of users and civil society in transport planning and monitoring through enhanced access to information. The recent protests in several cities in Brazil have highlighted the need for greater transparency in government and improved communication with users, and have underscored the strategic value of enhanced public involvement and oversight. Ensuring that users have access to the same information as the regulators can help to enhance users’ trust in the regulatory system and to align users’ priorities with those of the regulators or the Government. Recent international developments show that this alignment is best achieved by ensuring that key data – in this case service expectations and actual service quality data – is made available to the public through standard open protocols. This lowers the barrier for comparison and benchmarking.

72. Prior Actions. In support of the Government’s program, the operation focuses on a set of key policy actions to address the challenges of improving competitiveness, productivity and transparency of inter-municipal bus services, including:

The State has adopted a policy to: (A) replace existing permission-based route licenses for inter-municipal bus routes with competitively awarded concessions; (B) institute a performance-based system for managing said concessions; and (C) increase transparency in bus service performance for the public, as evidenced by State Decree 44.432 issued on 10/11/2013. (Prior Action #8).

73. The State Decree establishes the key principles for the concession of inter-municipal bus services, including: (i) adaptive integration of route plan with regional mass transit infrastructure, (ii) open competitive bidding (with no barriers to entry for non-incumbents), (iii) performance-based concession contract supervision, (iv) availability of monitoring data to the public; and (v) release of all data on performance for public access – in the form of reports and raw data (All raw data on schedules and system performance should be made available using open data protocols and formats such as GTFS and GTFS-real time).

74. The expected result of this policy reform is that the mobility conditions of people using inter-municipal buses will improve due to the introduction of modern services incorporating performance-monitoring and enhanced integration with mass transit under 15 Systems such as multimodal control and operation centers, advanced traffic signal systems, remote monitoring and enforcement systems (cameras, sensors, probes, software), and systems for traffic incident management, emergency response, electronic payment and pricing, and real-time user information.

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new open and transparent concessions with private operators. Progress towards the achievement of this result will be measured at three levels. A partially satisfactory result would be the identification, in the concession bidding documents, of the bus lines to be sectioned or eliminated in order to prioritize integration with mass transit modes. Successful execution of the concession process would constitute a fully satisfactory outcome during this period. Finally, enforcement of a performance-based network on the lines awarded would constitute a highly satisfactory outcome within this period. By the end of the operation (December 2014), the following results are expected:

The concession bidding documents will identify the bus lines to be sectioned or eliminated in order to prioritize integration with mass transit modes (name, current code, and in the cases of sectioning, new extension, new fleet and estimated demand). Baseline= 0 lines (December 2013) / Target = 19 lines are identified and reorganized or eliminated (December 2014)

Inter-municipal bus lines in the RJMR (previously provided under permission regime) are in operation under new concession agreements incorporating performance monitoring. Baseline= 0 lines (December 2013) / Target = 50% bus lines are awarded to competitively selected concessionaires (December 2014)

Service reliability, fleet modernization and vehicle occupation requirements are properly monitored and enforced on inter-municipal bus concessions in operation Baseline = N.A. (December 2013)/Target = 80% of bus concessions either comply with requirements or are penalized (December 2014)

Policy objective 2.3: Ensure the long-term sustainability and effectiveness of the State’s urban transport subsidy/affordability programs

75. Major progress has been achieved in increasing social inclusion and extending transport services and infrastructure to marginalized communities, but the availability and affordability of these services can be further improved in an effective and fiscally sustainable way. The SRJ currently subsidizes two important initiatives with significant social inclusion impacts: the operations of the cable car (teleferico) system and the implementation of the Bilhete Unico Intermunicial (BUI) fare policy. The Teleferico has been serving a group of low-income communities known as the Complexo de Alemão since 2011, and significantly subsidizes travel costs of community residents. The BUI or the ‘single pass’ is an integrated flat fare system that substantially cuts lower-income households’ expenses for transportation.16 It requires a significant subsidy which has grown dramatically in the last three years from R$ 217.6 million to R$ 456 million. These initiatives are important and have large impacts, but there is a need to ensure they remain fiscally affordable through appropriate design and targeting.

76. In the past, the SRJ has successfully implemented measures to enhance the financial sustainability of urban transport services and reduce reliance on public funding, particularly the rail system. Since 1998, GORJ has embarked on an aggressive campaign to promote private-sector participation in the urban transport sector, reduce fare evasion, cut costs and generate more non-operating revenues. This has led to the rationalization of some of the subsidies paid by the State. In particular, the State subsidy to the Supervia to support the operations of the rail system has decreased from US$121 million per year in 1997 to zero

16 The implementation of the BUI was a policy action supported by the Rio de Janeiro Metropolitan Urban and Housing DPL.

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currently, while fares stayed in line with the generalized increase in public transport tariffs region-wide.

77. To ensure that subsidized programs remain fiscally affordable and sustainable, an appropriate balance must be found between the need to fund system expansion/upgrading and operations adequately, and the need to maintain affordable tariff levels for the poor. International experience suggests a range of solutions including: ensuring appropriate operator incentives to promote efficiency and cost-recovery, targeting beneficiaries adequately, and using technology to improve operational productivity.

78. Prior Actions. The Government is taking action to preserve the affordability and improve the financial sustainability and cost-effectiveness of social inclusion initiatives in the transport sector. In this context, the proposed operation supports the institutionalization of sound technical analysis of subsidized urban mobility programs as follows:

The State has adopted a technical evaluation platform for periodic monitoring of the financial viability and cost-effectiveness of all transport programs requiring ongoing subsidies in an effort to ensure their financial sustainability, as evidenced by Resolution n. 1.113 issued by SETRANS on 10/10/2013 (Prior Action #9).

79. The resolution articulates the principles underlying such a technical audit including: periodicity (every 3 years) and components: (i) assess of operations to reconcile expenditures to usage; (ii) identify opportunities for targeting subsidies to the vulnerable; (iii) explore alternative regulatory frameworks to improve operational efficiency and maximize ancillary revenue for projects that support accessibility; (iv) examine possibilities for private sector participation; (v) explore use of new technologies; (vi) identify opportunities to leverage other social programs of the State; and (vii) evaluate potential program adjustments in light of new developments in transport.

80. The expected result of this prior action is the following: New operations contract awarded for the Teleferico System incorporates performance monitoring, availability-based remuneration, and incentives for maximizing ancillary revenue; and results in a reduction in the operational subsidies paid by the State. Baseline= System operated under temporary arrangement with a subsidy of R$14.00/passenger/trip / Target=new operational contract results in a 5% reduction in the subsidy per passenger/trip and is monitored and remunerated using performance indicators (December 2014)

Policy Area 3: Instituting policies and regulations to improve the availability of targeted social services aimed at reducing domestic and gender based violence

Policy Objective 3.1: To implement the Maria da Penha Law by leveraging transport infrastructure for improved delivery and targeting of gender-specific services

81. The State’s gender-specific programs are critical but suffer from a systemic lack of resources, limited staffing, poor inter-agency coordination and support, spatial and functional isolation, and, in particular, major accessibility constraints.

82. The GORJ intends to implement an innovative strategy of utilizing the existing Supervia and Teleferico transport infrastructure and network as a means to improve delivery of gender-focused services, at reduced establishment and operating costs. Currently, the Supervia only offers a transport service. In addition to transport, the Teleferico provides a range of social and economic services, including a Youth Reference Center, community activity spaces, limited food vending, art craft retail spaces, and a bank branch.

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83. Building on this, the GORJ is preparing the “Programa Supervia and Teleferico Lilas” (Supervia and Teleferico Lilac Program) (i) to increase access to information and to social and legal services to women as per the provisions of the “Lei Maria da Penha”, and (ii) to provide selected social and economic inclusion services to women customers of the Supervia and Teleferico systems. This new program is under preparation by SPM-RJ with World Bank technical assistance (Umbrella Facility for Gender Equality Trust Fund project: “Supervia and Gender Development”), and in close coordination with SETRANS and the Supervia and Teleferico Companies. Through the implementation of this program the State Government will seek to:

Selectively “populate” the Supervia and Teleferico stations with gender-focused resources and services such as Women Reference and Service Centers (“Salas Lilas”), Electronic Maria da Penha Law information points (“Totems Lilas”), and permanent and temporary information dissemination and campaign activities on anti-domestic and gender-based violence; and

Support the functional integration of the Supervia and Cable-car systems to the “Casa da Mulher Brasileira” (Brazilian Women’s House) of the “Programa Mulher Brasileira – Viver sem Violencia” through the establishment of adequate and sustainable transport links between them.

Coordinate with relevant (i) State and Municipal agencies the pilot establishment of a Women Police Station, a Women Clinic, and a Child-care center within the Supervia and Teleferico systems; (ii) private sector and/or NGOs the pilot establishment of vocational education (VET) and capacity development programs linked to pre-established employment opportunities, and the establishment of commercial retail stores with specific gender-based discount programs (drugstore, supermarket, etc.).

84. Prior Actions. The delivery of services for addressing the challenges of domestic and gender-based violence and improving gender equality in the RJMR is seen by the Government as a key strategy and means to improve the quality of life of women and achieve sustainable and shared prosperity. In this context, the proposed operation will support critical policy and institutional measures, including:

The State has established the Sub-secretariat of Policies for Women (“SPM-RJ/SEASDH”), as evidenced by State Decree 44.076 issued on 02/20/2013 (Prior Action #10); and

The State has: (A) adopted a policy to promote gender equality in the transport sector specifically focused on the women users of the transport system operated by Supervia; and (B) committed to implement the “Programa Supervia e Teleférico Lilás”, as evidenced by (A) Joint Resolution SEFAZ/SETRANS/SEASDH issued on 10/14/2013; and (B) the allocation of US$15 million (equivalent) to the SPM-RJ/SEASDH in the 2014 Borrower’s Budget Law Proposal published in the Official Gazette on 10/01/2013 (Prior Action #11).

85. The expected results of these prior actions are the following:

Number of women benefiting from increased access to information and to social and legal services as per the provisions of the “Lei Maria da Penha” within the Supervia and Teleférico systems. Baseline = 0 / Target =50,000 (2014)

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Increase in the number of women benefiting from the integration of the Supervia and Teleférico systems to access the “Casa da Mulher Brasileira”: Baseline = 0 / Target = 1,000 (2014)

86. All the gender service delivery activities of the program will be logged, monitored and accounted through the use of the "Bilhete Unico Integrado (BUI)" of the women customers. In addition, automated information points installed within the Supervia and Teleferico stations will automatically record statistics on usage and information accessed by users. The use of the BUI and the automated information points will further enable GORJ to undertake detailed geo-referenced analysis of gender service delivery activities.

87. The design of the Program and the selection of prior actions build upon extensive analytical work carried out as part of Bank operations or executed by the Government. The table below presents the main analytical underpinnings behind the Program’s prior actions.

Table 3: DPO Prior Actions and Analytical Underpinnings Prior actions Analytical Underpinnings

Pillar 1: Instituting policies for improved medium-term planning and monitoring of public expenditures Prior actions #1, to #4

The design of the PFM practices draws on a recent World Bank study on Medium Term Expenditure Frameworks,17 World Bank publications, as well as an IMF study on Public Financial Management.18 Finally, a study on Brazilian intergovernmental finance provide a precise analysis of the fiscal impacts of the proposed changes to inter-governmental financing arrangements.19

Pillar 2: Enhancing the quality and accessibility of urban mobility services for the poorPrior actions #5 to #9

The study ‘Safe Clean and Affordable Transport for Development’ (The World Bank’s Group Transport Business Strategy for 2008-2012) focuses on the critical role of an integrated system that provides users a seamless experience in improving the quality of a public transport experience in urban areas. There is also significant Bank and academic analytical work (se.g., Green and Inclusive growth Rio+20) that has made the case for the benefits of regulated competitively awarded concessions ‘for the market’ over route permissions (competition in the market) as a cornerstone of efficient modern bus systems. The SRJ’s reform plan is based on a detailed study ‘Estruturação Econômica do Processo de Outorga de Licitação de Linhas de Transporte Coletivo Intermunicipal de Passageiros por Ônibus’, that lays out the details of the proposed reform.

Pillar 3: Increasing the offer of targeted social services aimed at reducing domestic and gender-based violence Prior actions #10 and #11

WDR 2012 (Gender Equality and Development) established that gender equity is not only a key development outcome in its own, but it is also central to achieving other development outcomes. It found domestic and gender-based violence to be amongst the starkest manifestations of the lack of Equity and Agency, constitutes a violation of basic human rights, and negatively affects other key development outcomes, such as labor market or health outcomes.20 21

4.3 LINK TO COUNTRY PARTNERHSIP STRATEGY (CPS) AND OTHER BANK OPERATIONS

17 World Bank. (2012) Beyond the Annual Budget: Global Experience with Medium Term Expenditure Frameworks. 18 Cangiano, M., Curristine, T. & Lazare, M. (Eds.) (2013) Public Financial Management and Its Emerging Architecture International Monetary Fund, Washington DC 19 Araujo, J. and Barroso, R. (2013) Impact and Implications of Recent and Potential Changes to Brazil’s Subnational Fiscal Framework 20 See, for example, Neggers et al. (2004), Valladares et al. (2002), McFarlane, Parker and Soeken (1996), Aizer (2011) on the consequences of exposure to domestic violence in utero and Yount, DiGirolamo and Ramakrishnan (2011) for exposure in early childhood. 21 See: Perova, Reynolds, Müller 2013

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88. The proposed operation is fully consistent with and closely linked to the objectives of the CPS 2012-2015 discussed by the Executive Directors on November 1, 2011, which stresses the need for a programmatic approach in Bank interventions and stronger policy integration of transport and urban development. This new DPL will be an important component to support CPS outcomes across all four key pillars: (a) strengthen public and private investment; (b) improve service delivery to the poor; (c) strengthen regional and territorial development; and (d) support the effective management of natural resources and the environment.

89. The operation forms part of a long term engagement with the GORJ and is following: (i) the Fiscal Sustainability, Human Development and Competitiveness DPL that was approved in February 2010 (DPL1); (ii) the Rio de Janeiro Metropolitan Urban and Housing DPL that was approved in March 2011 (DPL2); and (iii) the Fiscal Efficiency For Quality of Public Service Delivery DPL that was approved in August 2012 (DPL3). The proposed operation will also have important synergies with the upcoming Renovating and Strengthening Public Management (PROGESTAO) - AF. From an urban mobility perspective, the proposed operation is closely linked to the on-going Rio de Janeiro State Upgrading and Greening the Rio de Janeiro Urban Rail System Project (P125630), which is supporting critical investments in the Supervia suburban rail system and enabling the provision of technical support to the State. Technical assistance is being provided through this project to the program of policy reforms supported by the DPL.

4.4 CONSULTATIONS AND COLLABORATION WITH OTHER DEVELOPMENT PARTNERS

90. Consultations. Rio de Janeiro’s development priorities, including the policies supported by this DPL, are embodied in the Government’s multi-year plan (PPA)22 and reflect not only rigorous technical analyses, but also a participatory decision-making process established in the State’s Constitution. The PPA, Annual Budget Law, and related government initiatives are regularly and extensively discussed at the State Assembly (Assembléia Legislativa do Estado do Rio de Janeiro), which has the authority to revise and approve the Government’s proposals. The PPA is the subject of an annual review by the State Assembly, at which time the Government reports on the previous year’s performance in meeting the objectives of the Plan.

91. Collaboration with other development partners. The Inter-American Development Bank (IDB) is providing technical assistance to: (i) enhance the planning, budget, and financial instruments that support the State’s decision-making process; (ii) increase the State’s internally-generated revenue; (iii) enhance transparency mechanisms and the efficiency, effectiveness, and control of public expenditure; and (iv) improve the quality of services provided to taxpayers by the State of Rio de Janeiro Secretariat of Finance (the Programa de Apoio à Gestão e Integração dos Fiscos no Brasil). IDB is also developing a series of actions to support the GORJ in Non-Motorized Transport (NMT) initiatives. The GORJ with World Bank support is seeking to secure additional resources to support its overall sectoral reform program.

22 Each president, governor or mayor must present a PPA, or Plano Plurianual (multi-year plan), on the first year of his/her mandate, establishing not only key priorities and strategies for the government`s long-term projects, but also the related budget plan. The PPA was established by a federal law and is more detailed and budget oriented than the strategic plan.

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5. OTHER DESIGN AND APPRAISAL ISSUES

5.1 POVERTY AND SOCIAL IMPACT

92. Overall, the specific policy reforms supported by this DPL are expected to have significant and positive poverty alleviation and social development impacts in Rio de Janeiro. The policies supported by this operation address key issues and needs related to historical social and spatial segregation in the RMRJ. They are expected to bring major benefits to the poor population particularly those living in informal settlements and in the periphery.

93. Most of the low-income (vulnerable to poverty, poor and extremely poor) families reside in peripheral municipalities.23 These poor and vulnerable populations heavily rely on public transportation for commuting and accessing job markets and public services which are concentrated in the capital city. They spend more time commuting than others, with low income women being disproportionally affected. In addition, employers are more reluctant to hire people from peripheral areas as they are obliged by law to pay 94 percent of the commuting fares to their formal employees, and because long commuting trips affect employees` productivity. The poor are also the most affected by the rising costs of the metropolitan transportation system. The RJMJ has the highest share of spending on transportation in family budgets compared to all other Brazilian metropolitan areas. This share has reached 17.3 percent in 2009. Persistent and above inflation increases in public transportation fares have contributed to increase this burden, resulting in reduced accessibility and/or motivation to use collective transport modes.

94. Large variances in urban mobility across the municipalities in the RJMR are associated with variances in indicators of poverty, income and formalization of the job market. Essentially, mobility barriers – due to issues related to accessibility, affordability, and time spent commuting – influence negatively the abilities of the low income population, living in peripheral areas, to search and compete for better paying jobs that are concentrated at the central areas. Thus, low income workers from peripheral areas are trapped into accepting more informal job posts, earn smaller wages and pay higher fares for commuting trips. Many people with low income who are trapped in “urban immobility” also face negative consequences in terms of access to some basic public services, and to leisure and social activities. Others rely on illegal, alternative, and unsafe transportation. These populations are expected to benefit the most from improvements in accessibility, reliability, and affordability introduced in the metropolitan transport system with the support of this operation.

95. The RMRJ’s urban mobility policies have been heavily criticized by key stakeholders. The unaffordability of public metropolitan transportation was the main issue raised by the public demonstrations that occurred in major Brazilian cities in June 2013. These public protests echoed the critique that public investments in the metropolitan transportation infrastructure have not yet brought improvements in the neediest areas, which have the worst urban mobility indicators. Finally, investments made in transport infrastructure have caused the involuntary resettlement of many poor families to most peripheral areas, contributing to increase spatial segregation and social exclusion.24

23 In 2010, extreme poverty, poverty and vulnerability to poverty rates reached 1.9 percent, 6.8 percent and 21.1 percent in the RMRJ, but peaked at peripheral municipalities. Extreme poverty and poverty rates peaked at Tanguá (4.9 percent and 14.4 percent, respectively), and the vulnerability to poverty rate peaked at Japeri (39.9%) 24 It is worth emphasizing that the State of Rio de Janeiro has taken the issue of involuntary resettlement of families seriously and has adopted measures that address stakeholders concerns. These measures include socially responsible and sensitive resettlement process favoring in situ or in nearby-areas relocation following the State Government's

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96. The urban mobility policies supported by this operation have the potential to help overcome the key bottlenecks faced by the metropolitan collective transportation system, with the highest benefits for the poor and vulnerable populations. Firstly, they promote better coordination between municipal authorities within the RMRJ and the operators of different public collective transportation modes (Prior Actions #5, #6, and #8), leading to a more efficient and rational integration between low and high capacity transportation modals, favoring collective over individual transportation, and promoting the integration of Non-Motorized Transport with the mass transportation systems, which together might improve access of the population to mass transportation system and reduce commuting time. Reduced commuting time will benefit the most the poorest people.

97. Secondly, these policies are expected to increase social accountability and gender mainstreaming in the management of the RJMR transportation system. They will also positively and significantly influence gender equality (Prior Actions #10 an #11) by (i) providing differentiated resources and services for women in the rail road and cable-car systems of transport, (ii) contributing to increase awareness on domestic and gender-based-violence and access to social and legal services, and (iii) promoting social and economic inclusion services..

98. Thirdly, these policies introduce a performance based model which will help contain fare increases through enhanced competition (Prior Action #8) and improve the sustainability of the Teleférico services (Prior Action # 9). In the RMRJ, the costs of public collective transportation are exclusively covered by fare collection and the final calculation of the fare is an apportionment of the total cost of transportation between the paying users of the system. This leads to a vicious cycle, in which fare increases lead to fewer passengers, resulting in subsequent fare increases, and so forth. Thus, all stakeholders who pay for fares (informal sector users not covered by transport fare subsidy, emergent middle class employees not eligible for subsidies, and employers who pay for the subsidies) will gain the most with the introduction of a performance-based model and the periodic review of all urban mobility programs that benefit from state subsidies.

5.2 ENVIRONMENTAL ASPECTS

99. It is expected that the policies supported by this operation which promote improvements in urban mobility will have significant positive environmental effects in terms of enhanced air quality and reduced carbon emissions. One of the main environmental problems in the Brazilian great cities is the pollution promoted by vehicles. In the RJMR, 77 percent of the air pollutants come from mobile sources,25 much of it from the 15000 buses operating in the region.26 The policy actions supported by this operation, which will lead to rationalization of inter-municipal bus routes and their integration with the regional rail and ferry systems, will lower vehicle emissions. The initiatives to improve NMT integration with the regional rail and ferry network will further reinforce these trends towards the use of lower emission public transport modes.

100. Additionally, rail and ferry systems in the RJMR are much less carbon intensive than buses and the actions supported by this operation should result in lower levels of

Decree 41148/2008, Decree 43415/2012, and Decree 43750/2012, on resettlement. These guidelines and mechanisms have been introduced in state practices. 25 INEA – Instituto Estadual do Meio Ambiente – www.inea.rj.gov.br/fma/qualidade-ar.asp#regiaometropolitana 26 PDTU 2011 – Plano Diretor de Transporte Urbano, Apresentação Preliminar e Parcial dos Resultados da Pesquisa Domiciliar (Atividade 6.4 – Parte 2). Rio de Janeiro, 07 de agosto de 2013.

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transport-related GHG emissions. Transport is already a significant source of GHG emissions nationwide (9 percent) and more so in urban areas.

101. Rio de Janeiro State has a Policy on Global Climate Change and Sustainable Development, established by Law 5690/2010 and regulated by Decree 43216/2011. The decree established that "emissions from the energy used in transport vehicles should be reduced by 30% (horizon – 2030) compared to 2010 (base year), with the expansion of rail and metro networks, ferry services, municipal and inter-cities bus systems as well as the increased use of biofuels". This operation will support this effort.

102. The State has put in place an appropriate set of environmental licenses to manage infrastructure development, and its institutional capacity to carry out environmental management has improved significantly in recent years. As such, the Rio de Janeiro State has the necessary institutional capabilities to supervise the environmental aspects of transport programs.

5.3 PFM, DISBURSEMENT AND AUDITING ASPECTS

103. A number of analytical studies underpin the Bank’s knowledge of the fiduciary environment in Rio de Janeiro27. A robust legal framework provided for in the Constitution and other relevant laws, and anchored in the Fiscal Responsibility Law of 2000, underpins Brazil’s public financial management systems. This legal framework provides for a strong PFM mandate at the sub-national level. The existence of federal laws and regulations for specific PFM areas helps to promote uniform requirements in PFM practices across sub-national entities. The framework provides for a clear definition of the responsibilities of federal and sub-national entities. In addition, institutional arrangements for the management of public finances are clearly established: SEPLAG is responsible for planning and budget preparation and SEFAZ is responsible for managing the Treasury, and for accounting and reporting processes. In addition, the Tribunal de Contas do Estado de Rio de Janeiro (TCE) is responsible for external scrutiny, and the legislature plays an external oversight role.

104. The budget classification system is governed by federal rules that are consistent with international standards. These rules also lay down specific requirements relating to the inclusion of comprehensive information in the budget documents. The budget preparation process is orderly, and is designed in such a way as to promote participation by all key stakeholders and sector agencies. The process is guided by well-defined budget preparation procedures and a calendar that establishes a proper sequencing of activities. The State has consistently met deadlines for the preparation of key budget documents and their submission to the legislature for consideration and approval. Furthermore, with the support of this operation, the Government is committed to improving the medium-term outlook in its planning and budgeting process.

105. The State’s performance in accounting for and recording transactions is fairly strong because accounting rules and regulations are generally respected. Some challenges have been noted in TCE reports, including those that have to do with the valuation of assets and

27 A review of the performance of the federal financial management and related information systems, as well as investment management efficiency, was completed in 2009 based on the PEFA methodology. In addition, the IDB completed a review of the fiscal management environment in the State in April 2009. Finally, a comprehensive assessment of the Debt Management functions of the State was carried out by the Bank in April 2011 using the World Bank’s Debt Management Performance Assessment methodology. The Bank also updated its knowledge of the PFM environment during the preparation of previous DPLs with the State of Rio de Janeiro.

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liabilities. The State’s information system, SIAFEM, is also adequate for most purposes, but various reviews have underlined the fact that it is based on an architecture that has not been updated for some time. In addition, some front-line service delivery units use separate systems, which may affect the quality and efficiency of budget monitoring and reporting for these units.

106. The financial programming process is working well. SEFAZ is responsible for formulating cash flow forecasts, as well as updating them and monitoring their implementation. To increase the predictability of budget execution and improve the relationship between planned activities and the availability of financing, the Government has embarked on a series of reforms to strengthen annual financial programming processes. It has also introduced measures that require suppliers to be paid in a timely manner. The use of the single Treasury account model of cash management and a clear allocation of responsibility for managing it facilitate the performance of bank reconciliations on a regular basis and in a timely manner.

107. The State’s PFM environment features strong internal rules and controls on commitments. However, a number of weaknesses still limit the effectiveness of the internal audit agency, the Auditoria Geral do Estado (AGE), which is responsible for providing management assurance on the functioning of the internal control system. The State intends to reform the institutional structure of the AGE in order to enhance its independence. SIAFEM also plays a key role in ensuring the implementation of internal controls.

108. There is a high level of transparency with respect to financial information in Brazil. This is made possible through the use of the internet and other public media channels to disseminate information on plans and budgets, as well as regular financial reports and annual financial statements. The State has consistently been able to prepare timely high quality financial statements. The Government is committed to ensuring that the quantity, quality, and format of this information are such that they enable a broad participation in budget preparation and monitoring of the execution processes. In addition, Brazil has established a timetable for the adoption of international public sector accounting standards (IPSAS) in all federal entities by 2014. The State is ahead of the schedule established for Brazil: its financial statements for 2012 were prepared on the basis of the new standards.

109. The mandate to audit the financial statements of the State is vested by the Constitution in the TCE, which is largely able to carry out audits of a reasonable scope. In the recent past, the TCE has been able to submit reports to the legislature (which is responsible for reviewing and approving the accounts) in a timely manner. Recommended actions are usually implemented, as is evidenced in the TCE’s reports. Legislative scrutiny of the budget and of the financial statements follows clear rules and procedures. However, there is a need for a more structured follow up of audit recommendations by the TCE, and for a more timely review of the reports by the State legislature in order to complete the accountability cycle.

110. As a result of the above review, the Bank is satisfied that the PFM environment in State of Rio de Janeiro is adequate to support the proposed operation. In addition, the Government’s development strategy and actions undertaken to implement reform actions are a satisfactory reflection of its commitment to improving the PFM environment.

111. The control environment governing the Central Bank’s operations within which the loan’s foreign exchange would flow continues to be adequate. The IMF undertook a Safeguards Assessment of the Central Bank of Brazil in October 2002 and updated it in March 2004. It concluded that the Central Bank does not present widespread vulnerabilities that could compromise the safeguarding of Fund resources. The Bank also undertook a review of the financial statements of the Central Bank to assess the extent to which the foreign exchange

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control environment continued to be adequate. As part of this review, the Bank examined the Financial Statements for the years ended December 31, 2006 to 2012. These included Explanatory Notes to the financial statements and a report of the independent audit carried out by an international firm of auditors. The latter contained an unqualified opinion on the financial statements for all years. In relation to operational risks, the Notes state that the Central Bank “uses internal control systems, which are considered adequate for its activities.”

112. The proceeds of the loan will be disbursed against satisfactory implementation of the DPL program and will not be tied to any specific purchases. Once the legal agreement is effective, disbursements of the loan will be made by the Bank into an account maintained by the State in a commercial bank that is deemed acceptable to the World Bank. Our assessment of the commercial bank was conducted to ensure that it was: (a) financially sound; (b) authorized to maintain the account in the currency agreed between the Bank and the borrower; (c) is audited regularly, and has received satisfactory audit reports; (d) able to execute a large number of transactions promptly; (e) is able to perform a wide range of banking services satisfactorily; (f) is able to provide a detailed statement of the account; (g) is part of a satisfactory correspondent banking network; and (h) charges reasonable fees for its services. We are satisfied that the bank meets these criteria, hence our conclusion.

113. The account will be denominated in foreign currency and will not form part of the foreign exchange reserves. However, the Central Bank will be informed of the deposit of this amount. Once the funds are deposited in the account, the commercial bank will credit an equivalent amount of money into an account of the State in the same bank that finances budget expenditures. The State will provide a confirmation to the Bank that: (i) the loan proceeds were received into the foreign currency denominated account, and (ii) an equivalent amount was credited to the account that finances budgeted expenditures. Such a confirmation will be sent to the Bank within 30 days after payment. Given that there are no delays expected between the date of disbursement from the World Bank and the credit of equivalent local currency funds in the State's budget management account, we do not envisage any material foreign exchange risks. If the proceeds of the loan are used for ineligible purposes as defined in the Development Loan Agreement, the Bank would require the State to refund the amount. Due to the conclusions related to the adequacy of the State’s public financial management environment, no additional fiduciary arrangements will be put in place for the operation.

114. In addition, it should be highlighted that procurement in the State of Rio de Janeiro is made in accordance with Federal and State legislation and except for small adaptations (the State has issued several decrees available at www.compras.rj.gov.br) it follows the same system as other states in the federation. The Federal framework of laws and regulations is solid and transparent, is well known by stakeholders, and takes precedence over those for the sub-national levels. Open competitive bidding is the default procurement method, as defined by Article 37 of the Constitution and provides fair opportunities for bidders. All procurement opportunities, regardless of estimated cost, are published via the internet. The State, as in other parts of Brazil, has faced several fraud and corruption cases related principally to limited competition in the procurement of civil works contracts.

5.4 MONITORING AND EVALUATION

115. The preparation of this operation is being led by Casa Civil (Office of the Chief of Staff), SETRANS and SEFAZ, with participation of the Sub-Secretaria de Politicas para a Mulher (SMP-RJ/ SEASDH). These agencies will be responsible for the overall

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implementation of the proposed operation, for reporting on progress, and for coordinating actions. A Project Implementation Committee (PIC) made up of officials from the agencies directly involved in the DPL-supported reform agenda will monitor implementation, including all essential technical assistance activities. In addition to monitoring and management systems, this project will support a number of evaluation activities that will generate data to inform State policies and thereby strengthen a culture of evidence-based policy-making.

116. The Program outcomes will be monitored through the measurement of the indicators included in the policy matrix. These indicators seek to assess progress towards the implementation of the reforms supported by the proposed DPL and will be evaluated one year following the disbursement of the loan. The PIC will be in charge of monitoring and reporting the Program’s outcome indicators.

6. SUMMARY OF RISKS AND MITIGATION

117. While the overall risk of the operation is substantial, the rewards of the operation are significant and have a potentially strong demonstration effect for other cities in Brazil. The confluence of the large international events, citizens’ protests and upcoming elections create an environment that favors the policy actions required in the loan. This combined with the World Bank’s on-going investment and TA operations with the State will help to mitigate the risks. More specifically, the most important risks include:

118. Macroeconomic and Fiscal Risks. The GORJ faces significant fiscal pressures associated with increasing expenditures on several on-going commitments in security, personnel, health and the investments needed (directly and indirectly) for the World Cup and the Olympics. At the same time some of the State’s main sources of revenue, which continue to be the ICMS tax revenue and oil receipts, remain susceptible to macroeconomic fluctuations in Brazil or abroad. Mitigating circumstances include: (i) the GORJ has demonstrated continued fiscal discipline and is committed to managing the fiscal repercussions of the global environment and of the sporting events prudently; (ii) the actions proposed in this DPL under the fiscal management component will contribute to increasing the State’s fiscal efficiency; and (iii) the recent approval by the Senate of a new sharing rule that would be applied to all royalties coming from all Pre-Salt fields, including those already licensed, despite reducing Rio’s share compared to previous legislation, reduces uncertainties on the revenue side, and prevents losses for producer states and municipalities.

119. Political and Governance-related Risks. Public demonstrations and unrest in June 2013 over the quality and price of public services may be reignited in the coming months, particularly if there are changes in the transport system, such as in the case of the inter-municipal bus concessions. There is a risk that increased public pressure may be used to justify a change in the pace of the reform process. Mitigation measures include a comprehensive public information and relations campaign to highlight the direct link between the reforms and improvements in the quality of urban mass transport services and how these reforms are responding to the points made in the demonstrations.

120. Bus Concessioning Process. The concessioning process for new bus routes is a high risk, high reward endeavor and several factors need to be aligned to fully realize the benefits of the process. The first important risk is that the process itself may be delayed if there are legal challenges. However, there is a confluence of events that suggest that this process will indeed proceed in the coming months as planned. Perhaps the most important of these are the public expectations created by the June 2013 protests and the heightened citizen interest in seeing improved quality of service delivery in the urban mobility sector. These expectations open a

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political window of opportunity for the State Government to deliver tangible results in time for the World Cup mega-event (June-July 2014) and for the State elections (October 2014). Further impetus is provided by a recent Supreme Court decision that asks the State to implement these new concessions in the next twelve months. Additionally, the concessioning process has been structured to mitigate risks as far as possible. Once the concessioning plan is final, and approved by the Tribunal of Accounts (an autonomous auditing body that needs to approve all new government policy initiatives) it will be subject to a structured public consultation process – which is expected to build further support for this process. The Bank will also be supporting the finalization of the plans by way of the technical assistance as part of ongoing investment loans.

121. Even if the concessioning process proceeds as planned, considerable risks remain. The bidding documents that emerge from the process may not truly facilitate open bids. The bids may not be able to attract a truly competitive field. The contracts may not have the right combination of incentives and penalties to align operator interests with high performance. Finally, the regulator may not be able to effectively monitor performance or influence operator behavior. These risks are mitigated by: (i) supporting the process with technical reviews of the bidding documents and route plan; (ii) ensuring that specific concerns have been addressed and key principles have been articulated in the decree; and (iii) involving users and civil society in the performance monitoring process, by making all performance data public using open data protocols. Additionally, technical assistance will be provided through existing Bank operations to strengthen capacity and upgrade systems in the State regulatory agencies involved in the management of transport concessions.

122. Gender related Policies and Institutions. Given the high level of coordination required between SPM-RJ, SETRANS, the Supervia and Teleferico companies, and a number of other sectorial State and Municipal agencies, the private sector and the NGO community for successful implementation of the “Supervia and Teleferico Lilac Program”, there is a risk that this high level of inclusiveness might come at the cost of efficiency in implementation. Furthermore, adequate funding by the State could pose a risk to effective implementation of the “Supervia and Teleferico Lilac Program”. Several elements of the design of the program will help mitigate that risk, including: (i) the establishment of an inter-sectorial “Gender Working Group” co-Chaired by SETRANS and SPM-RJ, which are the Program proponents; (ii) the publicly-stated commitment of Supervia and Teleferico to the Program, which they see as a mean to increase and sustain service ridership; and, (iii) the allocation of US$15 million (equivalent) to SPM-RJ in the 2014 State budget.

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ANNEX 1. LETTER OF DEVELOPMENT POLICY

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UNOFFICIAL TRANSLATION LETTER OF DEVELOPMENT POLICY

GOVERNMENT OF THE STATE OF RIO DE JANEIRO

OFFICE OF THE GOVERNOR

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ANNEX 2. OPERATION POLICY MATRIX – RESULTS INDICATORS

Prior Actions Results

Policy Area 1: Instituting policies to improve medium-term planning and monitoring of public expenditures

Policy Objective 1.1 - Adopt sound financial and debt management policies and practices

Prior action #1: The State has adopted the legal framework to implement its treasury’s operational risk policy, which policy provides for, inter alia, mandatory disclosure of related documents on the internet and the State’s submission to yearly external audits of said policy. Evidence: State Decree n. 44.428 issued on 10/11/2013 and published in the Official Gazette on 10/14/2013. [completed]

Maintenance of the number of events (occurrences and non-conformities) in which the operational risk policy procedures were not complied with within already achieved satisfactory levels Baseline= [occurrences = 52; non-conformities = 12] (2012) Target = [occurrence = 48; non-conformities = 11] (2014)

Prior action #2: The State has established the legal basis for the use of sound financial and debt management tools, such as budget and financial quotas, minimum and average cash balance, and procedures for making payments to its suppliers. Evidence: State Decree n. 44.429 issued on 10/11/2013 and published in the Official Gazette on 10/14/2013. [completed]

Reduction in the number of times in a year that the actual monthly cash balance has remained below the minimum threshold (set at 1.5 times the payroll amount). Baseline= 3 out of 12 (2012) Target = 2 out of 12 (2014)

Reduction in the percentage of payments made after 30 days. Baseline= 3.6% (2012) Target = 3.0% (2014)

Policy Objective 1.2 - Strengthen the definition of the budget resource envelope under a Medium-Term Expenditure Framework (MTEF)

Prior action #3: The State has adopted the following budget preparation practices to improve its accountability and fiscal discipline: (A) preparation, publication and regular updating of detailed revenue estimates including subsequent years’ estimates; and (B) issuance of an annual budget directive setting appropriate sectorial budget ceilings, which shall be consistent with the medium term revenue forecasts and targets for public indebtedness. Evidence: State Decree n. 44.431 issues on 10/11/2013 and published in the Official Gazette on 10/15/2013. [completed]

Reduction in the gap between actual and estimated current revenues, measured as a share of the estimated revenues. Baseline= 6.6% (average 2010-2012) Target = 5% (2014)

Publication in the internet of revenue estimates documents for the 2014 budget. Baseline= No (2012) Target = Yes (2014)

Annual Budget directive issued for the 2015 budget cycle. Baseline= No (2012) Target = Yes (2014)

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Prior Actions Results

Policy Objective 1.3 - Implement a framework to manage fiscal commitments originated from Public-Private Partnerships (PPPs)

Prior action #4: The State has adopted the following institutional practices to improve its transparency and accountability: (A) regular publication of a comprehensive estimate of fiscal commitments, including explicit and contingent payments from effective and prospective PPP contracts, which estimates shall be updated at least annually together with the annual budget law; and (B) publication of all documents and analysis relating to PPP projects through a specialized website. Evidence: State Decree n. 44.430 issued on 10/11/2013 and published in the Official Gazette on 10/14/2013. [completed]

A comprehensive report including current and prospective long-term commitments and liabilities associated to PPPs is published as scheduled. Baseline= No (2012) Target = Yes (2014)

All PPP-related bidding documents, contracts and supporting analysis are published on a dedicated website in a timely manner. Baseline= No (2012) Target = Yes (2014)

Policy Area 2: Instituting policies and regulations to improve the accessibility, quality and affordability of urban mobility services for the poor

Policy Objective 2.1 - Foster modal and regional integration in urban transport systems

Prior action #5: The State has: (A) adopted the Urban Transport Master Plan (PDTU) as the policy framework for the planning and development of an integrated transport system in the RJMR; and (B) established a formal coordination mechanism to enable the State, the academia, civil society institutions and RJMR municipal governments to participate in the implementation of the PDTU. Evidence: State Decree n. 44.433 issued by the Governor’s Office on 10/11/2013 and published in the Official Gazette on 10/14/2013 [completed]

Permanent Committee for the implementation of the PDTU, involving relevant government and civil society actors, meets at least four (4) times in its first year of existence and presents strategy for the implementation of at least one (1) priority project under the PDTU. Baseline = Formal committee to accompany implementation of the PDTU does not exist ( December 2013) Target =4 meetings and 1 PDTU project discussed (December 2014)

No transport project outside of the PDTU (i.e. not endorsed by PDTU) will be undertaken by the GORJ.

Prior action #6: The State has taken a first step to initiate the implementation of a policy to physically integrate municipal and state-managed mass transit systems in the RJMR.   Evidence: Memorandum of Understanding entered into between the State and Supervia for the implementation of multimodal integration projects signed on 08/22/2013 [completed]

At least one (1) multimodal integration project (part of the PDTU), connecting state and municipal transit systems, is completed Baseline = 0 (December 2013) Target = 1 (December 2014)

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Prior Actions Results

Prior action #7: The State has adopted a new policy to promote non-motorized transport (NMT) through which it will: (1) ensure that secured bicycle parking will be available at all major transit stations in the RJMR; and (2) provide technical assistance to RJMR municipalities in developing high quality NMT access to major public transport stations. Evidence: Resolution n. 1.114 issued by SETRANS on 10/10/2013 and published in the Official Gazette on 10/14/2013 [completed].

State prepares guidelines for the development of bicycle-public transit integration projects to be implemented by metropolitan municipalities and at least one (1) of these projects is implemented with the State’s technical assistance. Baseline = 0 projects (December 2013) Target = 1 project (December 2014)

Policy Objective 2.2 - Enhance the performance and transparency of inter-municipal bus services

Prior action #8: The State has adopted a policy to: (A) replace existing permission-based route licenses for inter-municipal bus routes with competitively awarded concessions; (B) institute a performance-based system for managing said concessions; and (C) increase transparency in bus service performance for the public.  Evidence: State Decree 44.432 promulgated on 10/11/2013 and published in the Official Gazette on 10/14/2013 [completed].

The concession bidding documents will identify the bus lines to be sectioned or eliminated in order to prioritize integration with mass transit modes (name, current code, and in the cases of sectioning, new extension, new fleet and estimated demand). Baseline = 0 lines (December 2013) Target = 19 lines are identified and reorganized or eliminated (December 2014).

Inter-municipal bus lines in the RJMR (previously provided under permission regime) are in operation under new concession agreements incorporating performance monitoring. Baseline = 0 lines (December 2013) Target = 50% of the bus lines under the new route plan are awarded to competitively selected concessionaires (December 2014)]

Service reliability, fleet modernization and vehicle occupation requirements are properly monitored and enforced on inter-municipal bus concessions in operation Baseline = N.A. (December 2013) Target = 80%of bus concessions either comply with requirements or are penalized (December 2014)

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Policy Objective 2.3 - Ensure the long-term sustainability and effectiveness of the State’s urban transport subsidy/affordability programs

Prior action #9: The State has adopted a technical evaluation platform for periodic monitoring of the financial viability and cost-effectiveness of all transport programs requiring ongoing subsidies in an effort to ensure their financial sustainability. Evidence: Resolution n. 1.113, issued by SETRANS on 10/10/2013 and published in the Official Gazette on 10/14/2013. [completed]

New operations contract awarded for the Teleferico System incorporates performance monitoring, availability-based remuneration, and incentives for maximizing ancillary revenue; and results in a reduction in the operational subsidies paid by the State. Baseline= System operated under temporary arrangement with a subsidy of R$14.00/passenger/trip (2013) Target=new operational contract results in a 5% reduction in the subsidy per passenger/trip and is monitored and remunerated using performance indicators (December 2014)

Policy Area 3: Instituting policies and regulations to improve the availability of targeted social services aimed at reducing domestic and gender based violence Policy Objective 3.1- Implement the Maria da Penha Law by leveraging transport infrastructure for improved delivery and targeting of services

Prior action #10: The State has established the Sub-secretariat of Policies for Women (“SPM-RJ/SEASDH”). Evidence: State Decree 44.076 issued on 02/20/2013 and published in the Official Gazette on 02/21/2013. [completed].

Number of women benefiting from increased access to information and to social and legal services as per the provisions of the “Lei Maria da Penha” within the Supervia and Teleférico systems: Baseline = 0 (December 2013) Target =50,000 (December 2014)

Prior Action #11: The State has: (A) adopted a policy to promote gender equality in the transport sector specifically focused on the women users of the transport system operated by Supervia; and (B) committed to implement the “Programa Supervia e Teleférico Lilás”. Evidence: (A) Joint Resolution SEFAZ/SETRANS/SEASDH n.167 issued on 10/14/2013 and published on the Official Gazette on 10/15/2013; and (B) the allocation of US$15 million (equivalent) to the SPM-RJ/SEASDH in the 2014 Borrower’s Budget Law Proposal published in the Official Gazette on10/01/2013. [completed].

Increase in the number of women benefiting from the integration of the Supervia and Teleférico systems to access the “Casa da Mulher Brasileira”: Baseline = 0 (December 2013) Target = 1,000 (December 2014)

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ANNEX 3. FUND RELATIONS NOTE

IMF Executive Board Concludes 2013 Article IV Consultation with Brazil Press Release No. 13/314 August 28, 2013

On July 26, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Brazil.1

During the last decade, Brazil’s strong macroeconomic frameworks have contributed to preserve macroeconomic stability, support robust growth, and underpin sustained poverty reduction. The key pillars of Brazil’s macroeconomic frameworks have been the fiscal responsibility law, the inflation targeting regime, and the flexible exchange rate. In addition, a strong prudential framework has underpinned a sound financial sector that withstood well the global financial crisis of 2008–09. The prolonged macroeconomic stability has facilitated the adoption of far-reaching social programs that have produced a remarkable social transformation—in particular, a substantial reduction in poverty and the increase in living standards of large segments of the population.

Brazil’s economy is recovering gradually from the slowdown that began in mid-2011. Consumption remained resilient last year underpinned by low unemployment and broad gains in real wages, although it has slowed somewhat more recently. After a protracted period of weakness, investment has begun to recover in recent quarters while business confidence has firmed. With the economy estimated to be operating close to potential, supply-side constraints have restrained near-term growth and exacerbated inflationary pressures. Low unemployment has also contributed to demand-pull and cost-push inflation pressures. End-of-period inflation, the reference measure for inflation-targeting in Brazil, has been below the upper limit of the 4½ ± 2 percent target range for several years; it has been running however in the upper range of the target band, while medium-term inflation expectations have risen above the mid-point target. The authorities have started to focus on alleviating supply-side constraints (including infrastructure bottlenecks) and containing inflationary pressures by tightening monetary policy.

The external current account deficit has widened, reflecting weaker external demand, buoyant consumption and, more recently, a pickup in investment and temporary disruptions in oil production. The real exchange rate depreciated over the last year, most recently as part of a broader realignment across emerging markets. At the same time, unit labor costs in U.S. dollars have remained broadly unchanged, limiting the impact on competitiveness, as the effect of the weaker currency has been offset by rapid growth in real wages and stagnant labor productivity gains. Capital inflows, particularly portfolio flows, subsided in 2012 linked to a weaker growth outlook and lower interest rates in Brazil, and the use of capital flow measures. More recently, global financial volatility and higher global risk aversion have further dampened portfolio inflows to Brazil. Equity prices have declined and corporate debt and equity issuances have slowed, in line with other major emerging markets. Foreign direct investment inflows, however, have remained robust. International reserves have remained broadly stable at a high level following a halt in reserves accumulation since mid-2012.

Financial conditions have tightened but credit growth has remained strong, driven by public banks’ lending. Mortgage lending has continued to grow strongly, but remains a relatively small share of total credit. Real estate prices, though moderating, have continued to increase. The authorities have made progress in implementing key recommendations of the 2012 Financial Sector Assessment Program (FSAP) Update.

57

Executive Board Assessment

Executive Directors commended the Brazilian authorities for their long-standing commitment to sound policy frameworks, notably the fiscal responsibility law, inflation targeting, the flexible exchange rate, and a strong prudential regime. They noted that these frameworks, together with the implementation of social programs, have underpinned macroeconomic stability and remarkable growth over the past decade, lifting living standards and reducing poverty.

Directors observed that, in addition to headwinds from external conditions, domestic supply-side constraints and policy uncertainties may be holding back near-term growth. A tighter policy stance would help address persistent price pressures, safeguard confidence in policy frameworks, and set the stage for a medium-term rebalancing of demand away from consumption. In this context, Directors welcomed the initiation of a monetary tightening cycle, and agreed that monetary policy should remain geared at containing inflationary pressures and anchoring inflation expectations. They underscored the need for a steady, measured pace of fiscal consolidation, anchored on Brazil’s long-standing primary surplus target. Some Directors saw a continued role for fiscal stimulus as a counter-cyclical tool. More generally, Directors considered that monetary policy should play the main role in aggregate demand management, with fiscal policy focused on rebuilding buffers.

Directors highlighted the importance of adhering to a primary surplus target that places public debt firmly on a downward path. They encouraged efforts to maintain fiscal discipline at the sub-national level, ease budget rigidities to increase public savings, and recognize more fully potential fiscal risks associated with public bank assets and infrastructure concession agreements. Directors also recommended a gradual reduction of policy lending to public banks to improve debt dynamics. A number of Directors considered that a more detailed assessment of Brazil’s public debt encompassing net and gross concepts would permit an enhanced interpretation of fiscal developments and prospects.

Directors welcomed the substantial progress in strengthening financial regulation and supervision. They observed that Brazil’s banking system is sound and well placed to implement Basel III ahead of schedule. Directors noted nevertheless that some risks, notably those associated with household credit and mortgage loans, warrant ongoing vigilance. They welcomed the progress in implementing most of the recommendations of the recent Financial Sector Assessment Program Update.

Directors concurred that the flexible exchange rate remains the main shock absorber in periods of financial turbulence, and welcomed the authorities’ intention to limit interventions in the foreign exchange market to moderating excessive volatility. They agreed that Brazil has an adequate toolkit to deal with capital inflow pressures, by allowing the exchange rate to appreciate somewhat, supported by other policies, including some further temporary reserve accumulation and carefully-considered capital flow management measures.

Directors supported the focus of reforms to ease supply-side constraints, noting that the Government’s market-based concessions program would boost investment and alleviate infrastructure bottlenecks. They emphasized that comprehensive efforts to boost productivity, competitiveness, and investment are critical for raising potential growth. To this end, it will be important to increase domestic saving, improve the minimum wage indexation mechanism, and continue to reform the pension system. Other efforts to foster private investment should include streamlining taxation and improving business conditions.

58

2006 2007 2008 2009 2010 2011 2012

National accountsGDP at current prices 10.4 12.3 13.9 6.8 16.4 9.9 6.3

GDP at constant prices 4 6.1 5.2 -0.3 7.5 2.7 0.9

Private consumption 5.2 6.1 5.7 4.4 6.9 4.1 3.1

Public consumption 2.6 5.1 3.2 3.1 4.2 1.9 3.2

Gross Investment 8 15.6 15.6 -17.7 31.1 3.1 -9

Exports 5 6.2 0.5 -9.1 11.5 4.5 0.5

Imports 18.4 19.9 15.4 -7.6 35.8 9.7 0.2

PricesConsumer price index (IPCA, period average)

4.2 3.6 5.7 4.9 5 6.6 5.4

Consumer price index (IPCA, end of period)

3.1 4.5 5.9 4.3 5.9 6.5 5.8

GDP deflator 6.1 5.9 8.4 7.1 8.3 7 5.4

Terms of trade 5.3 2.1 3.5 -3.2 17 7.8 -5.8

Public financesFederal government 1/

Nonfinancial revenue 2/ 23 23.3 23.6 22.8 24.4 23.9 24.1

Primary expenditure 20.9 21.1 20.6 21 22.6 21.6 22.5

Primary balance 2.2 2.2 2.8 1.3 1.8 2.2 1.7

Nonfinancial public sectorPrimary balance 3.3 3.5 4.1 2.2 2.5 3.2 2.1

Net interest payments 6.8 6.1 5.5 5.3 5.2 5.7 4.9

Overall balance -3.5 -2.7 -1.4 -3.1 -2.7 -2.5 -2.8

Policy lending 3/ -2.3 -2.7 -2.1 3.2 2.7 1 1.5

Nonfinancial public sector gross debt 4/

67 65.2 63.5 66.8 65 64.7 68

Public sector net debt 5/ 47.3 45.1 38 41.5 39.1 36.4 35.2

Money and creditBase money 6/ 12.6 21.8 -17.4 11.3 131.8 10.8 -13.6

Broad money (M2) 7/ 18 18.7 17.8 16.3 15.8 18.5 16.6

Credit to the private sector 21.7 30.1 28.1 13.7 23 20.2 15.8

Balance of paymentsCurrent account 13.6 1.6 -28.2 -24.3 -47.3 -52.5 -54.2

Merchandise trade balance 46.5 40 24.8 25.3 20.1 29.8 19.4

Exports 137.8 160.6 197.9 153 201.9 256 242.6

Imports -91.4 -120.6 -173.1 -127.7 -181.8 -226.2 -223.2

Services, income, and current transfers (net)

-32.8 -38.5 -53 -49.6 -67.4 -82.3 -73.6

Capital and financial account 16.3 89.1 29.3 71.3 99.6 109.4 76.7

Foreign direct investment (net) -9.4 27.5 24.6 36 36.9 76 68.1

Portfolio investment (net) 4.3 37.9 3.5 50.5 56.4 31.2 8.2

Other capital (net) 21.3 23.7 1.3 -15.2 6.3 2.2 0.4

Errors and omissions 0.6 -3.2 1.8 -0.3 -3.5 -1.3 3

Change in net international reserves 32 94.5 13.4 44.7 50.1 63.4 21.1

Current account (in percent of GDP) 1.3 0.1 -1.7 -1.5 -2.2 -2.1 -2.4

Outstanding external debt (in percent of GDP)

15.8 14.1 12 12.2 12 12.1 14.1

Debt service ratio (in percent of exports of goods and services)

45.4 44.8 24.8 34.2 25.9 23 23.6

Gross reserves/short-term external debt (residual maturity, in percent)

100 231.3 235.5 314.6 269.8 394.6 474.3

(In billions of U.S. dollars, unless otherwise indicated)

Brazil: Basic Data, 2006-2012

(Annual percentage changes, unless otherwise indicated)

(In percent of GDP)

(12-month percentage changes, unless otherwise indicated)

59

ANNEX 4. FISCAL SUSTAINABILITY ANALYSIS

1. Since 2007, fiscal adjustment has allowed the State to reduce its relative debt levels while undertaking a major increase in investment. However in 2012 for the first time in many years the primary balance became negative. The overall balance was negative in three out of the last four years. Nonetheless, a clear improving trend can be seen after 2009, apart from the downturn in 2012.

Figure A4.1: Rio de Janeiro: Evolution of Fiscal Balance: 2008 – 2012 (current values) 28

Sources: Secretaria de Fazenda, State of Rio de Janeiro

2. Rio de Janeiro’s revenues are largely composed of taxes, oil royalties29 and transfers. These three revenue groups constitute 89 percent of the total revenue in 2012, with taxes accounting for two thirds of all revenues, while royalties account for 15.5 percent and transfers for 7 percent. Tax revenues are derived mainly from ICMS (VAT on goods and services), with all other taxes such as motor-vehicle tax collecting around 20 percent of the ICMS revenues. The main transfers are the State Participation Fund (FPE) and the IPI-exportação, which is a transfer from the federal tax on industrialized products to compensate for the exemption of ICMS for exported manufactured goods. Lastly, the State of Rio de Janeiro is responsible for 75 percent of the oil production in Brazil, receiving therefore under the current oil royalties sharing rule the largest revenue share.

3. Revenue growth has been uneven in recent years. ICMS has posted the largest growth rate: 10.8 percent annually in nominal terms, as a result of increasing imports, better enforcement and the high GDP growth rate experienced in 2010. On the other hand, transfers and royalties have grown 4.9 and 5.2 percent respectively. The lower growth rate in transfers is mainly attributable to the tax cuts introduced by the federal government in shared taxes to stimulate the economy, while the growth of royalties has been hampered by the appreciating exchange rate from 2008 to 2012 (except for the overshooting period during the crisis) and the absence of new auctions for oil wells explorations.

28 Calculated in accordance to the Brazilian fiscal statements standards. 29 The State of Rio de Janeiro classifies royalties as an own source revenues rather than transfers.

‐1.5

‐1.0

‐0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0

10

20

30

40

50

60

70

2008 2009 2010 2011 2012

R$ Billion

R$ Billion

Total Revenues Total Expenditures

Overall Balance Primary Balance

60

Figure A4.2: Rio de Janeiro: Evolution of Main Revenue Items: 2008 – 2012

Sources: Secretaria de Fazenda, State of Rio de Janeiro

4. Rio de Janeiro’s main expenditure items are compensation of employees, legally mandated transfers to municipalities and goods and services. These three items account for 89 percent of expenditure (Table ). Investments have increased to 10 percent of revenue by 2012. Lastly, although Rio has a relatively high debt level, the debt service burden is manageable. The interest bill amounted to 6 percent of total expenditure in 2012, while total debt service (interests plus amortization) took up less than 10 percent of the state revenues.

5. Investment has been the fastest growing expenditure since 2008, however payroll expenditures almost doubled (in nominal terms) in the same period. Government investments grew 34.4 percent on average every year from 2008 to 2012, going from R$ 1.6 billion in 2008 to 5.3 billion to 2012. This increased investment reflects the adjustments made by the Government since taking office, but also its ability and the willingness of the National Treasury to allow Rio to borrow at a faster pace than before. Higher investments and loans are also related to the World Cup and Olympics that Rio will be hosting in 2014 and 2016. Payroll expenditures which refer to working civil servants grew at an average annual rate of 17.7 percent. The more pronounced and recent increase in the payroll reflects the wage increases granted by the State Government particularly to police and teachers, who make up a majority of the payroll. These raises were given in response to strikes, similar raises given at the Federal level and the perceived improvement in the security police represented by its flagship program UPP. In addition, the number of security personnel increased significantly in this period: going from less than 50,000 in January of 2008 to more than 73,000 in August of 2013. Overall, the number of public employees increased from 240,376 to 259,298 in the same period.

19.6 20.622.1

27.329.5

2.7 2.7 2.9 3.3 3.3

6.74.9

6.4 7.08.2

0

5

10

15

20

25

30

35

2008 2009 2010 2011 2012

R$ Billion

ICMS Transfers Royalties

61

Table A4.1: Rio de Janeiro, Statement of Government operations, 2008-2012, Billions of R$

Sources: Secretaria de Fazenda, State of Rio de Janeiro and World Bank calculations

2008 2009 2010 2011 2012I. REVENUE 39.9 37.8 45.1 51.0 53.1

Taxes 22.9 24.9 29.1 32.6 35.1ICMS 19.6 20.6 24.4 27.3 29.2IPVA 1.2 1.5 1.4 1.5 1.7OUTRAS 2.1 2.8 3.3 3.7 4.2

Social Contributions 0.9 0.9 1.0 1.2 1.3Transfers 2.9 3.3 3.7 4.3 3.8

Current Transfers 2.7 2.7 2.9 3.3 3.3Capital Transfers 0.2 0.6 0.7 1.0 0.5

Other Current Revenues 13.1 8.7 11.3 13.0 12.9

II. EXPENSE 34.5 37.0 42.3 47.4 52.6Compensation of Employees 16.4 18.1 20.9 23.3 26.7Interest Payments 2.3 2.3 2.3 2.5 2.6Other Current Expenditures 14.5 15.3 17.3 19.7 21.0

Transfers to Municipalities 5.5 5.9 7.0 8.4 8.8Goods and Services 9.0 9.4 10.4 11.3 12.2

III. GROSS OPERATING BALANCE (I - II) 5.4 0.8 2.8 3.6 0.5% of NCR 16.9 2.7 8.2 9.1 1.2

IV. TRANSACTIONS IN NON-FINANCIAL ASSETS 1.8 2.9 5.3 5.0 5.5Investiment in Non-Financial Assets 1.6 2.7 5.2 4.7 5.3

V. NET LENDING / BORROWING (III - IV) 3.6 -2.1 -2.5 -1.4 -5.0

VI. PRIMARY BALANCE (V + Net Interest Payments) 5.3 -0.3 -0.7 0.4 -2.9% of NCR 16.8 (1.0) (1.9) 1.1 (7.2)

VII. TRANSACTIONS IN FINANCIAL ASSETS ANDLIABILITIES -0.5 -0.3 0.4 0.4 2.8

New Loans 0.2 0.3 1.3 1.3 4.8Amortizations, net -0.7 -1.0 -1.0 -1.4 -2.0

VIII. GROSS FINANCING NEEDS (Net Debt Service - VI) 2.4 2.8 2.8 3.3 4.1% of NCR 7.5 9.6 8.0 8.3 10.1

VIII. OVERALL BALANCE (VI + VII) 4.8 -0.6 -0.3 0.8 -0.2

Memo Items:Net Current Revenue (NCR) 31.8 29.0 34.5 39.3 40.6Non-Financial Investment / NCR 5.1% 9.4% 15.0% 12.0% 13.1%Debt 50.9 47.2 53.9 57.3 66.2Debt/NCR 160.0% 163.0% 156.0% 146.0% 162.9%Debt/State GDP 15.0% 13.4% 13.3% 12.9% 14.0%

62

Figure A4.3: Rio de Janeiro: Evolution of Main Expenditure Items: 2008 -2012

Sources: Secretaria de Fazenda, State of Rio de Janeiro

6. Despite recent turbulence, Rio de Janeiro has remained in compliance with the Fiscal Responsibility Law targets throughout the period. The ratio of Net Consolidated Debt (NCD) to Net Current Revenues (NCR) has remained under the 200 percent threshold, reaching 162.9 percent (equivalent to 14% of State GDP) in December of 2012. The limit on the value of guarantees given, which is 22 percent of NCR, has also been abided with. The value of the outstanding guarantees has remained under 6 percent of NCR since 2004. Lastly, consolidated personnel expenditures amounted to R$ 15.8 billion in 2012, which corresponds to 39 percent of NCR, well below the 60 percent limit.

Figure A4.4: Personnel Expenditure / Net Current Revenues: 2008 – 2012

Sources: Secretaria de Fazenda, State of Rio de Janeiro

7. Although Rio’s debt level is rising and may present some challenges in the medium term, debt is managed prudently in the state. Rio’s debt stock is largely denominated in local currency and owed to the federal government (83 percent of total debt stock). Interest rates are

6.67.5

8.79.2

12.7

1.6

2.7

5.24.7

5.3

0

2

4

6

8

10

12

14

2008 2009 2010 2011 2012

R$ Billion

Payroll Pensions Interest Payments Investments

23.9

27.0 26.8 26.3

29.6

0

5

10

15

20

25

30

35

2008 2009 2010 2011 2012

Executive Legislative Judiciary Public Attorney

63

mostly fixed and maturities are long, with new loans being contracted with at least a 10 year final maturity. The major risks are the exchange rate risk either directly through the loans denominated in foreign currency or indirectly through the domestic debt that is indexed to the general price index (although this may be offset by rising revenues from imports) and the build-up of a debt residual in the debt originated from the 1997 debt renegotiation with the federal government.

8. Fiscal arrangements between the State, Federal and Municipal governments are deemed appropriate. Transfers are the result of a stable rule based system which implies that net transfers will move broadly in line with overall revenues. Transfers accounted for less than 10 percent of total revenues in the past years. Rio’s net transfers are negative, as transfers to the municipality exceeded current and capital transfers from the Federal Government. In addition, the state is a net loser in the redistribution scheme promoted by FUNDEB (see Box 1 on Fiscal Arrangements).

Box A4.1: Intergovernmental Fiscal Arrangements in Brazil Brazil is a federative country made up of 26 states, plus the Federal District. There are also 5,564 municipalities. Each level of government is allowed to raise its own revenues through specific tax bases. The responsibility for collecting taxes is broadly consistent with economic principles that suggest that mobile tax bases need to be taxed by the central government while immobile bases should be taxed by sub-national governments.

Broadly speaking, the federal government can levy taxes on personal income (IRPF) and corporate profits (IRPJ), industrial products (IPI), financial operations (IOF), fuels (CIDE), rural property (ITR), and imports (II). The federal government can also levy social contributions on corporate profits (CSLL), and payroll (social security contributions) and corporate revenues (PIS/COFINS). Social contributions are meant to finance health, social protection, and social security expenditures. In contrast to tax revenues, social contributions are not shared among subnational governments.

The largest tax source for state governments is VAT (ICMS, value added tax on goods and services). In addition, they can also impose a tax on personal property such as motor vehicles (IPVA), and on donations and inheritances (ITCMD). Two of the three taxes collected by the state are shared with the municipalities, which receive 25 percent of ICMS and 50 percent of IPVA. The municipalities have the right to tax urban property (IPTU), services (ISS), and the transfer of property (ITBI).

Figure 5: Tax Assignment and Intergovernmental Transfer in Brazil

64

Rio de Janeiro Debt Sustainability Analysis 9. The sustainability of the Rio de Janeiro fiscal position was assessed through a projection of general government revenues, expenditures and debt. The main revenue and expenditure items are projected taking into consideration their determinants as well as other exogenous factors that might impact them in order to determine a baseline scenario. The analysis then proceeded to carry out stress tests for a number of adverse scenarios including the impact of a reform of royalties (which would affect Rio de Janeiro’s income from oil), persistent slow growth, a revenue shock and significant additional spending on investment prior to the major sporting events of 2014 and 2016.

10. The main challenge on the revenue side is the disappearance of three revenue items in the short and medium-term. The first one is the extinction of the revenue stream provided by the Certificados Financeiros do Tesouro (CFT), a federal government bond which was given to the state of the Rio de Janeiro in exchange of future royalties payments. This revenue had an anticipated declining profile and ended in 2012. In the same year, revenues from CIDE, a federal government contribution charged on fuels and partially transferred to the states also ended, due to the decision of the federal government to zero its rate in order to curb inflationary pressures. Lastly, the ICMS additional tax rate over selected products, the so-called Eradication Poverty Fund (FECP), which has collected R$ 2.5 billion in 2012, is foreseen to end in 2014. Overall, these three items represented R$ 3.3 billion (6.2 percent) of revenues in 2012.

11. The main assumptions for the baseline revenue and expenditure projections are shown in the table below. Own revenues are expected to increase in line with the economy – inflation and GDP growth. The projections for the transfer revenue was done based on the federal government forecasts and according to inflation and GDP growth when not available. The new FPE coefficient was introduced as mandated by the Law 143/13 in 2015, in line with the gradual transition foreseen in the same law. The collection of tax arrears is also expected to decline in 2013 and 2014 due to the amnesty promoted in the end of 2012.

12. On the revenues side, most items are expected to grow with inflation and GDP or just inflation. The payroll for both working and retired civil servants is assumed to grow along with inflation and GDP, which implies slower growth than in recent years. In addition, a tighter stance is projected for 2015, the first year of the new government. Transfers are estimated to grow in line with the respective transferred tax.

65

Table A4.2: Rio State Fiscal and Debt Baseline Projection Assumptions

13. The forecast shows a state with a positive gross operating balance, but with financing needs due to its heavy investment program. As a result, primary balance will be negative until 2016 although gradually falling from 7.2 percent of NCR in 2013 due to the heavy investment program, catalyzed by the World Cup and by the Olympics. It should be noted that much of the investment linked with these events are investments in transport and urban development, which would have been required anyway, but have been accelerated due to the events of 2014 and 2016.

14. The base scenario is built around the business as usual scenario. This means that revenues and expenditures are assumed to evolve as in the past and it is only altered unless a change is already determined such as in an approved law or is judged most likely to happen. Nonetheless, there are several risks to this baseline scenario.

Variables Assumption

Revenues

Tax Revenues

ICMS Increase with IPCA inflation and GDP growth. FECP rate to end in 2014

Other taxes Increase with IPCA inflation and GDP growth.

IRRF Increase with payroll expenditures

Social Contributions Increase with payroll expenditures

Transfers

Current Transfers Estimated from Fed. Government forecasts. CIDE transfers to end in 2012.

Capital Transfers Fixed at R$ 500 million/ year.

Other Current Revenues

Interest Revenues Increase with IPCA inflation.

Non‐Financial Asset Revenues Increase with IPCA inflation.

Other Current Revenues Increase with IPCA inflation.

Expenditures

Compensation of Employees Increase with IPCA inflation and GDP growth.

Interest Payments In accordance with contractual payments provided by SEFAZ

Other Current Expenditures Increase with IPCA inflation.

Transfers to Municipalities Increase with respective tax.

Goods and Services Increase with IPCA inflation.

FUNDEB Net Loss Increase with respective taxes. Net loss is assumed at 46% of gross contribution.

Capital Expenditures

Investiment in Non‐Financial Assets Equal to current saving and loan proceeds.

Investment in Financial Assets

New Loans In accordance with loan being negotiated provided by SEFAZ.

Amortizations receivedAmortizations paid In accordance with contractual payments provided by SEFAZ

Asset sales Increase with IPCA inflation.

Base year figures ‐ 2012

66

Table A4.3: Fiscal Baseline Projections: Rio de Janeiro Statement of Government Operations (GFS classification), 2013-2017, R$ billion, current values

Sources: Secretaria de Fazenda, State of Rio de Janeiro and World Bank calculations

Rio could suffer a significant loss from the approved change in oil royalties sharing30 scheme. The change in royalties was approved by Congress and then vetoed by the president, but its veto was overturned by Congress. The new law was not put into effect due to an injunction issued by the Supreme Court at the request of three states (including Rio). Rio would benefit

30 See the estimates in the recent Intergovernmental Finance ESW Report (P132347).

I. REVENUETaxes

ICMSIPVAOUTRAS

2012 2013 2014 2015 2016 201753.1 57.4 62.8 65.1 71.9 78.735.1 38.5 42.5 43.1 47.8 52.529.2 32.0 35.4 35.4 39.2 43.1

1.7 1.9 2.1 2.3 2.6 2.84.2 4.5 5.0 5.5 6.1 6.5

Social ContributionsTransfers

Current TransfersCapital Transfers

Other Current Revenues

1.3 1.4 1.5 1.7 1.9 2.03.8 4.3 4.6 4.9 5.2 5.63.3 3.6 3.9 4.2 4.5 4.90.5 0.7 0.7 0.7 0.7 0.7

12.9 13.2 14.1 15.4 17.0 18.7

II. EXPENSECompensation of EmployeesInterest PaymentsOther Current Expenditures

Transfers to MunicipalitiesGoods and Services

52.6 56.2 61.3 65.1 70.9 74.926.7 28.3 31.3 34.2 37.8 39.8

2.6 2.9 3.1 3.2 3.2 3.021.0 22.6 24.4 25.0 26.9 28.8

8.8 9.6 10.6 10.8 12.0 13.112.2 13.0 13.8 14.2 15.0 15.7

III. GROSS OPERATING BALANCE (I - II)% of NCR

IV. TRANSACTIONS IN NON-FINANCIAL ASSETSInvestiment in Non-Financial Assets

0.5 1.1 1.4 0.0 1.0 3.71.2 2.6 3.0 0.0 1.8 6.3

5.5 6.6 6.8 5.3 4.2 3.55.3 6.4 6.6 5.1 3.9 3.2

V. NET LENDING / BORROWING (III - IV)

VI. PRIMARY BALANCE (V + Net Interest Payments)% of NCR

VII. TRANSACTIONS IN FINANCIAL ASSETS ANDLIABILITIES

New LoansAmortizations, net

-5.0 -5.4 -5.4 -5.3 -3.2 0.3

-2.9 -3.1 -2.9 -2.8 -0.8 2.6(7.2) (7.2) (6.2) (5.6) (1.4) 4.3

2.8 3.8 4.7 1.8 -1.7 -3.44.8 6.3 7.2 4.7 1.6 0.6

-2.0 -2.6 -2.5 -2.9 -3.3 -4.0

VIII. GROSS FINANCING NEEDS (Net Debt Service - VI)% of NCR

VIII. OVERALL BALANCE (VI + VII)

Memo Items:Net Current Revenue (NCR)Non-Financial Investment / NCRDebtDebt/NCRDebt/State GDP

4.1 4.9 5.0 5.5 5.8 6.310.1 11.4 10.6 11.1 10.6 10.6

-0.2 0.7 1.7 -0.9 -2.4 -0.8

40.6 43.2 47.3 49.2 54.3 59.613.1% 14.7% 13.9% 10.3% 7.2% 5.4%

66.2 75.7 85.6 95.6 104.1 109.1162.9% 175.1% 181.1% 194.3% 191.5% 183.1%

14.0% 14.7% 15.0% 15.4% 15.2% 14.5%

67

from the changes in ICMS being discussed, but the gain would not be sufficient to compensate fully the losses in royalties. Additionally, the changes in ICMS are less likely to happen.

15. On its own the change in the royalties sharing scheme would represent an average loss of 7 percent of NCR compared to the baseline scenario. Nevertheless it is recognized that even if an adverse settlement of the royalties issue were to occur there would almost certainly be some offsetting mechanisms (in terms of transfers from other pooled resources). Thus an alternative scenario was developed in which the State of Rio would lose the equivalent of half of the revenue from Royalties over the projection period. Without other adjustments, this would translate in worse fiscal balances throughout the period. In particular, the gross operation balance would become negative throughout the period, as would the primary balance. In addition, the overall balance would turn negative, thus the state would have to reduce holdings of financial assets and make some adjustments in both revenues and expenditures in order to avoid arrears. This scenario is illustrative in that it assumes that the revenue shortfall is not made up from other sources, and that there is no adjustment of expenditures. In practice it is likely that, particularly from 2016 onwards, the State would be able to contain current spending and investment, so as to put debt on a downwards path from 2016.

Table A4.4: Effects of change in royalties revenue distribution on fiscal projections: 2013-2017, (R$ Billions)

Sources: Secretaria de Fazenda, State of Rio de Janeiro and World Bank calculations

16. The scenarios suggest that despite the risks Rio’s debt will reach a peak in 2015 or 2016 and will decline thereafter. In the baseline the pressures of the high investment push the debt up to 194 per cent of Net Current Revenue, and that thereafter it begins to decline. In the scenario in which there is a shock due to the loss of oil royalties, the level of debt does exceed 200% (reaching 215 percent of Net Current Revenue). While this value is formally above the LRF limit of 200 percent, it would not imply any sanctions by the Federal Government, since loans contracted for the purposes of financing infrastructure for the World Cup and Olympic Games have been deemed not to count for the purposes of sanctions under the LRF. It should also be noted that while above the LRF limits, even in the second scenario debt reaches the equivalent of 15.8 percent of State GDP. In other circumstances the revenue shock due to the loss of royalties would probably have been accommodated through reductions in investment and other spending. However given the high profile of the international events, this would not be a plausible scenario until 2016.

Additional stress tests

17. In addition to the analysis of the impact of a loss of royalty income, an analysis was made of a number of alternative adverse impacts on the fiscal position of the State of Rio de Janeiro. These are: i) lower growth, ii) higher investment requirements, iii) higher wage bill, iv) revenue shock. The assumptions underlying each of these shocks are shown in Table 4 below:

2013 2014 2015 2016 2017 2013 2014 2015 2016 2017

Revenues 57.4 62.8 65.1 71.9 78.7 57.4 61.2 62.9 68.9 74.8

Expenditures 56.2 61.3 65.1 70.9 74.9 56.2 61.3 65.1 70.9 74.9

Gross Operating Balance 1.1 1.4 0.0 1.0 3.7 1.1 ‐0.2 ‐2.2 ‐2.0 ‐0.1

% of NCR 2.6 3.0 0.0 1.8 6.3 2.6 -0.4 -4.7 -3.9 -0.3Primary Balance ‐3.1 ‐2.9 ‐2.8 ‐0.8 2.6 ‐3.1 ‐4.5 ‐4.7 ‐3.3 ‐0.8

% of NCR 2.6 3.0 0.0 1.8 6.3 2.6 -0.4 -4.7 -3.9 -0.3Overall Balance 0.7 1.7 ‐0.9 ‐2.4 ‐0.8 0.7 0.2 ‐2.9 ‐4.9 ‐4.2

Debt 75.7 85.6 95.6 104.1 109.1 75.7 87.1 99.2 110.4 119.2

% of NCR 175.1 181.1 194.3 191.5 183.1 175.1 190.8 211.1 214.9 213.9% of State GDP 14.7 15.0 15.4 15.2 14.5 14.7 15.3 16.0 16.1 15.8

Baseline Scenario With change in Royalties

68

Table A4.5: Assumptions for Debt sustainability stress tests

Royalty sharing loss Rio de Janeiro loses half the revenues from royalties from 2014 to 2017

Prolonged GDP shock GDP grows 2% less annually compared with the baseline

Additional investment costs State investment increased by 20% over baseline from 2014 to 2017 Revenue shock Revenues five percent below baseline from 2014

Wage shock Wages grow two percent annually above the baseline from 2014 to 2016

Combined shock GDP shock plus royalty loss plus investment costs

18. The shock which has the greatest potential impact on the debt position of Rio de Janeiro is the royalty loss. In this case debt rises to almost 215 percent of net revenues (or 16.1 percent of State GDP). The other two potentially most important shocks are the GDP and revenue ones, which have very similar impacts on the debt profile, with the debt peaking at about 205 percent of net revenue in each case. Both the investment and wage shocks raise debt close to the 200 percent FRL limit, but do not breach it. Finally a worst case scenario was developed combining the royalty, growth and investment shocks. This is the only case where, understandably, the debt continues to increase as a proportion of net revenues. In such an adverse scenario, there is little doubt that the State of Rio de Janeiro would have to make a major adjustment to spending and revenues to revert the increasing tendency of the debt.

19. It is notable that in all scenarios, except the combined shock, even without major policy changes, debt levels begin to revert after 2015 or 2016. While it is clear that debt levels will rise above those observed in the last few years, they should not be seen as unmanageable, particularly with a government which is clearly focused on maintaining fiscal sustainability. The spending of the last two years and the next two, is clearly exceptional, and includes major urban infrastructure in the water and transport sector that can support future growth in Rio, particularly with the development of the Pre-Sal oil fields. Finally it is important to note that while higher than in the past, even in the worst scenarios, debt levels only rise to about 18 per cent of State GDP.

20. The overall conclusion of the debt sustainability analysis is that under any even under the pressures of expenditure for the major events in 2014 and 2016, although there will be a temporary rise in the debt until 2015, this can be accommodated and will not pose a threat to long term sustainability.

69

Figure A4.5: Stress tests to the debt sustainability scenario

Sources: Secretaria de Fazenda, State of Rio de Janeiro and World Bank calculations

120%

130%

140%

150%

160%

170%

180%

190%

200%

210%

2011 2012 2013 2014 2015 2016 2017

Baseline

Growth shock

120%

130%

140%

150%

160%

170%

180%

190%

200%

210%

2011 2012 2013 2014 2015 2016 2017

Baseline

Investment shock

120%

130%

140%

150%

160%

170%

180%

190%

200%

210%

2011 2012 2013 2014 2015 2016 2017

Baseline

Revenue shock

120%

130%

140%

150%

160%

170%

180%

190%

200%

210%

2011 2012 2013 2014 2015 2016 2017

Baseline

Wage shock

120%

140%

160%

180%

200%

220%

240%

260%

2011 2012 2013 2014 2015 2016 2017

Baseline

Combined

70

ANNEX 5. BRAZIL AT A GLANCE

71

 

72

ANNEX 6. RIO AT A GLANCE

Rio at a glance

Key Development Indicators

Mid-2013

Population, mid-year (millions) 1,A 16.4 201.0

Surface area (thousand sq km) A 44 8,515

Average population growth (2001-2013, %) 1,A 0.98 1.29

Urban population (% of total population)(2010) 1,A 97 84

2010

GDP (current prices, US$ billions) 2,B,C 231 2,143

GDP (current prices, R$ billions) C 407 3,770

GDP per capita (current prices, US$) 2,B,C,D 14,474 10,992

GDP per capita (current prices, BRL) C,D 25,464 19,339

GDP growth (%) C 4.46 7.53

GDP per capita growth (%) D 6.5 6.6

2011

Extreme Poverty headcount (National poverty line ) 3,F 3.9 6.9

Poverty headcount ( National poverty line ) 3,F 16.0 20.6

Gini F 0.532 0.529

Poverty headcount ratio at $1.25 a day (PPP, %) (2009)E 3.5 6.1

Poverty headcount ratio at $2.00 a day (PPP, %) (2009) E 5.8 10.8

2009

Life expectancy at birth (years) G 73.8 73.3

Infant mortality (per 1,000 lives births) - 20104 H 14.2 16.2

Child malnutrition (% of children under 5) - 2010 G 1.4* 1.9

*Southeast region

Adult literacy (% of ages 15 and older) A 95.7 90.4

Net primary enrollment (% of age group) I 98.1 97.6

Access to improved water source (% of households) 5,I 88.1 84.4

Acces to improved sanitation facilities (% of households) 6,I 84.6 59.1

Government Finance J

2001 2010 2001 2010

Net current revenues 8.9 8.5 12.9 13.3

Tax Revenue 6.8 7.1 7.5 7.5

Current Expenditure 10.5 10.4 15.6 22.6

Overall surplus/deficit NA -1.6 -1.9 -1.2

Primary Surplus 0.7 0.3 1.7 2.1

.. .. .. ..

(% of GDP)

Rio de

JaneiroBrazil

Rio de JaneiroBrazil

(Central Government)

2.07 1.90

2.35

2.01 2.04

1.90 1.72

1.74 1.60 1.63 1.56

1.46

1.65 1.55

0.0

0.5

1.0

1.5

2.0

2.5

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013*

DC

L/R

CL

Deb

t a

nd

Ne

t C

urr

en

t R

eve

nu

e

(R$

bn

of

201

3)

NCD/NCR NCD NCR

RJ Net Consolidated Debt (NCD) and Net Current Revenue NCR), 2000-2013*

* un l April 2013

73

Rio de Janeiro

Long-Term Economic Trends

1980-1991 1991-2000 2000-2010

1980 1991 2000 2010

Brazil 119.0 146.8 169.8 190.8 1.93% 1.63% 1.17%

Rio de Janeiro 11.3 12.8 14.4 15.9 1.14% 1.32% 1.00%

1995-2000 2000-2005 2005-2009

1995 2000 2005 2010

Brazil 705.64 779.48 894.24 1,111.72 2.01 2.78 4.45

Rio de Janeiro 78.94 92.36 102.87 120.05 3.19 2.18 3.14

Brazil 769.74 425.79 367.12 631.90 Rio de Janeiro 86.12 50.54 42.24 68.24

Economic Sector C

1995 2000 2005 2010 1995-2000 2000-2005 2005-2010

Brazil 5.8 5.6 5.7 5.3 3.27 4.18 3.77

Rio de Janeiro 0.8 0.7 0.5 0.4 0.27 2.31 -1.26

Brazil 27.5 27.7 29.3 28.1 1.08 2.50 3.14

Rio de Janeiro 19.6 24.0 30.2 28.1 -0.61 1.91 2.44

Brazil 18.6 17.2 18.1 16.2 0.25 2.9 1.99

Rio de Janeiro 9.8 9.8 10.2 9.9 -3.61 -0.26 0.43

Brazil 0.8 1.6 2.5 3.0 3.06 6.36 4.26

Rio de Janeiro 1.2 5.7 12.0 9.8 12.64 8 1.51

Brazil 66.7 66.7 65.0 66.6 2.13 2.9 4.58

Rio de Janeiro 79.6 75.3 69.3 71.5 1.53 2.1 3.69

(average annual growth %)

(average annual growth %)

Population, mid-year (millions) 1,A

GDP (constant price 1995, BRL billion) 2,B,C

GDP (constant price 1995, US$ billion) 2,B,C

(average annual growth %)

Extractive

Services

(% of GDP)

Agriculture

Industry

Manufacturing

6 Access to sewage disposal system or to septic tank connected to disposal system per household (IBGE Tables)

Sources: A - Census 2010/IBGE; B - IMF WEO; C- Regional Accounts/IBGE; D- IBGE; E - WB; F- IPEA using PNAD/IBGE; G- Ministry of Health/Datasus; H- Ministry of Health/MS/SVS/DASIS/CGIAE; I- PNAD/IBGE; J- National

Treasury

1 Numbers refer to Census 2010 very recently released by IBGE. The 194.9 billion population for Brazil that appears on the text and table Brazil at a Glance refers to the official IBGE's estimate of total population for 2010, which was

available at the time of preparation of the the document and released before the Census was concluded. Note: those figures were updated using IBGE population estimates for July 2013

Notes:

2 GDP and GDP per capita data for Brazil were taken from IMF WEO survey. The values for the State of Rio de Janeiro were estimated using share in total GDP (IBGE regional accounts) and population estimate for 2009, both from

IBGE

3 Extreme porverty line here is estimated as a consumption basket with the minimum necessary calories for a person's adequate survival according to WHO. Poverty line is twice the value of the extreme poverty line.

4 Administrative data using Active Search (Busca Ativa)5 Access to water network supply per household (IBGE Tables)